SL Advisors Talks Markets

Liberal Energy Policies Remain Good For Investors

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The energy transition’s long overdue reassessment was already under way by the time Russian missiles began falling on Ukraine. Fear of stranded assets has been replaced by the sudden need for energy security.

At a recent JPMorgan energy conference, CEO Jamie Dimon repeated his call for a new “Marshall Plan” to ensure energy security for the US and our allies. Appropriately this took place during a “fireside chat” with Cheniere CEO Jack Fusco, who noted that his company provided 1/3^rd of Europe’s natural gas imports during 1Q22. Many have noted that there can be no energy transition without energy security. Few companies are more important to Europe in avoiding natural gas rationing this winter.

In JPMorgan’s annual report, Dimon reminded that, “… using gas to diminish coal consumption is an actionable way to reduce CO2 emissions expeditiously.” Dimon is no climate change denier but is pragmatically identifying profitable business for the bank. Purists fret that building new infrastructure to support imports of Liquefied Natural Gas (LNG) means locking Europe in to burning fossil fuels for several decades, inconsistent with the UN zero by 50 mission. Meanwhile, German wholesale electricity prices one year out have breached €200 per MWh, up 4X over the past year.

Capital investment in future oil and gas production has been falling for years. The poor returns following the shale bust are the immediate cause, but the message from policymakers has been clear. Oil and gas look like a risky long term investment when governments are promising to stop using fossil fuels just as soon as they can. Now western leaders are acknowledging the public’s ephemeral concerns about climate change, which last until the costs are visible. Higher oil doesn’t seem to have caused a spike in windmill prices. St Augustine* might have said “Lord, give me renewables, but not yet.”

The problems of underinvestment aren’t limited to oil and gas. Goldman’s Jeff Currie expects oil prices to reach $140 per barrel during the summer. In a recent CNBC interview he said, “At the core of our bullish view of energy is the underinvestment thesis.” Currie noted that this month’s pullback in energy sector equity prices would exacerbate the problem by reflecting a withdrawal of capital from a sector that needs it in order to increase production.

The International Energy Agency (IEA) expects global crude oil demand to increase by 2% next year, taking it above pre-Covid levels to a new all-time high. US airline fares are up 38%. In spite of this, more people are flying around the world, with the aviation sector representing 5% of crude oil demand. International travel is growing the fastest.

Although global capex is up this year among the world’s biggest oil and gas companies, it’s still down by around a fifth from 2019. This downtrend dates back to pre-Covid, when policymakers were freely vilifying the energy industry. The collapse in prices in 2020 was a further incentive to impose financial discipline.

There’s an illuminating clip from the recent G7 meeting during which French President Macron tells President Biden that the United Arab Emirates is producing at maximum capacity while the Saudis have perhaps a small amount of extra capacity, for the next six months. One might think that Biden wouldn’t need a foreign leader to point this out to him, but this Administration’s energy policy does remind of the Keystone Kops.

Fortunately, in its final communique the G7 said investment in liquefied natural gas was a “necessary response to the current crisis”. It added: “In these exceptional circumstances, publicly-supported investment in the gas sector can be appropriate as a temporary response.”

With gasoline prices rising and little prospect of relief, it’s not hard to see the Republicans running as the party of cheaper energy. They have little useful to say on curbing emissions, so the appeal of such a message will reflect Americans’ concern about climate change. White House actions suggest that they believe only the liberal wing is willing to rapidly phase out fossil fuels. They’ve assessed that swing voters care more about what they pay at the pump.

Therefore, a Republican-controlled Congress following the mid-terms could pass legislation supportive of increased investment in domestic oil and gas production – by making it harder for endless court challenges to block infrastructure projects for example. Signing or vetoing such a bill would offer an uncomfortable choice for a lame duck president.

For now it seems meeting demand growth for traditional energy will drive prices higher. There’s little sign of demand destruction at current levels, and China is still enduring partial lockdowns.

*St Augustine is credited with saying, “Oh Lord, give me chastity, but do not give it yet.”

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

The Fed Can’t Afford Two Mistakes

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Amid the more hawkish Fed and consequent sharp drop in the market, the jump in real yields has not drawn much attention. The rise in ten year yields came with inflation expectations remaining well anchored at around 2.75%. TIPs yields rose with nominal ones.

Factset earnings expectations don’t yet reflect the pessimism of public company CEOs, the majority of whom expect a recession within 12-18 months. That view relies on the expectation that the Fed will tighten excessively in their zeal to control inflation.

It’s a fascinating problem trying to predict the FOMC’s actions. Warren Buffett often responds that he never considers the economic outlook when analyzing investments, but some of these CEOs presumably do when making capital allocation decisions.

Meanwhile, the eurodollar futures curve has steepened somewhat but also has an increasing gap between yields five years out and longer compared with the FOMC’s equilibrium rate. The Fed’s latest projection materials show the median member’s forecast at 2.5% for the neutral policy rate. Futures markets have it closer to 3.25%.

It reminds of the Fed’s past poor record at forecasting (see from 2019 Bond Market Looks Past Fed). For many years after the great financial crisis of 2008-09, the bond market implied lower rates than the Fed. The bond market was right. Today circumstances have reversed, and interest rate markets are forecasting a higher neutral rate than the FOMC.

This is likely to be correct because the Fed’s reinterpreted mandate favors maximizing employment over stable prices. Therefore, inflation is likely to remain above their 2% target because they’ll be wary of the recessionary risk of extended tighter policy. Raising rates with inflation at 8% is not controversial. When unemployment is in the mid 4%s and rising while inflation is at 4% and falling is when the Fed will more clearly need to consider the employment/inflation trade-off. Even with the Fed moving at 0.75% increments, the 4% rate cycle peak represents little if any premium over then current inflation.

Today’s market prices support this view. So there’s some asymmetry every time important economic data is released, such as the employment report on the first Friday of the month. Signs of weakness will likely drive two year treasury yields lower and the market to anticipate the Fed moving to neutral or slower pace of rate hikes.

Coupled with this, the Equity Risk Premium (ERP) is starting to favor stocks again. Just two months ago we noted that the market wasn’t that attractive compared with bond yields (see Criticism Of The Fed Goes Mainstream). Since then, stocks have slumped 15%, and even though interest rates have risen stocks are more attractively priced. Bottom-up 2023 S&P500 earnings assume 9% earnings growth, which puts the ERP at 3.5, comfortably wider than its 2.5 two decade average. Even though ten year yields have been rising, bond prices seem to be permanently supported by return-insensitive holders (central banks) and rigid investment mandates (pension funds). The ERP is only likely to favor fixed income over stocks when the market is truly frothy – not its present state.

If soft economic data causes investors to price in a more moderate Fed, the equity market is poised for a strong rally.

A couple of weeks ago when I was on The Compound and Friends, Josh Brown’s weekly interview that’s published on Youtube, I suggested that we might look back at this period as the good old days. Josh and his co-presenter Mike Batnick were shocked. “There’s nothing more scary than a pessimist with a British accent” became that episode’s trailer. I explained my point, which is that although criticism of the Fed flows freely, they have achieved full employment – if anything they’ve over-achieved it.

Apart from those heavily invested in the energy sector, inflation is making many feel poorer since real incomes are falling. But at least everyone is coping with higher prices with a job. A few million people will need to lose theirs in order to reduce inflation for everyone. When that happens criticism of the Fed will take on a different form. If one policy error (a slow response to inflation) is followed by another (a recession caused by over-responding to the first), Powell’s congressional appearances will become uncomfortable.

That analysis is why it’s worth betting on the Fed claiming a premature victory over inflation. They can’t afford consecutive policy errors, so inflation is unlikely to return to their 2% target. Pipeline stocks have endured a sharp fall this month, but the strong fundamentals remain intact, and dividend yields have moved a little higher with the sell-off. In our opinion midstream energy infrastructure is attractively priced.

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

Hydrocarbons Support The Four Pillars Of Civilization

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Vaclav Smil is a polymath whose prolific writing on energy has produced his latest book, How the World Really Works. You read Smil slowly, taking time to digest the facts and conclusions that are his trade. He combines expertise across several disciplines to explain the technology and inputs supporting modern western lifestyles.

In Fossil Future, Alex Epstein notes the substantial improvements that traditional energy have brought to humanity and argues that we should be celebrating not vilifying the hydrocarbons that make this possible. Smil demonstrates that the world will remain dependent on fossil fuels for the foreseeable future with data-based arguments.

The first three chapters of How the World Really Works, explain how indispensable agriculture, steel, cement and plastics are to civilization. Smil reminds us that, “Modern history can be seen as an unusually rapid sequence of transitions to new energy sources, and the modern world is the cumulative result of their conversions.” He estimates that coal provided half of England’s heat by 1620, but even by 1850 only 7% of fuel energy in Europe and North America.

Shifting the transportation sector to electric vehicles and decarbonizing power generation generate media interest, but start with agriculture to understand how the world feeds its 8 billion people. In 1800 98% of the US labor force was engaged in farming. Producing a kilogram of wheat required ten minutes of labor. Today it’s two seconds – 98% lower, along with the proportion of our workers engaged in agriculture.

The entire production process has benefited from fossil fuels – tractors pull plows manufactured with steel. Combine harvesters collect and process the crop. Propane is used to dry it. Trucks transport it farther down the production line. Refrigeration reduces spoilage. Around 1920 one quarter of US farmland was dedicated to growing feed for the 25 million working horses and mules.

Nitrogen-based fertilizers have dramatically increased yields. Manure, which used to be laboriously spread on fields, contains less than 1% nitrogen whereas urea, the world’s dominant solid nitrogenous fertilizer, is 46% nitrogen. Over the last century corn yields in America have increased from two tons per hectare to 11. Natural gas is converted into ammonia, a key input into urea production. Around the world, farming efficiencies have enabled population growth.

It’s unclear how even small portions of modern food production could be migrated away from traditional energy. There is no known substitute for fertilizers derived from natural gas. Battery-powered farm vehicles are implausible. Returning agriculture to its form of a century ago would leave the world unable to support its current population. It’s not going to happen. Moreover, on current trends we’ll add a further two billion people, mostly in developing countries, by 2050. Smil concludes that, “…without the synthesis of ammonia, we could not ensure the very survival of large shares of today’s and tomorrow’s population.”

Smil refers to cement, steel, plastics and ammonia as “the four pillars of civilization”. Global production of these four “indispensable materials” requires 17% of the world’s primary energy and generates a quarter of fossil fuel CO2 emissions. Cement and steel require substantial heat, generated with coal (or coal dust) and coke. Plastic is a product of hydrocarbons such as methane (natural gas), ethane, propane or oil.

Recycled steel is almost 30% of global steel output and is 70% in the US. It can be melted in an electric arc furnace, which sounds promisingly as if it could be powered with renewables. But the energy required to reach a temperature of 1,800 degrees Celsius is enormous. Even the most efficient furnace requires the electricity of an American city of 150,000 people. Iron ore, from which steel is derived, is almost limitless. World resources are estimated at 800 billion tons, compared with annual production of 2.5 billion tons.

Smil estimates that for Electric Vehicles (EVs) to reach 25% of the global fleet by 2050, output of lithium and cobalt would need to increase by at least 15X; nickel by 28X. He estimates 40 tons of ores per EV. With global auto sales running at 100 million annually, 25 million EVs would mean mining a further 1 billion tons of ore every year.

Concrete and steel are the basis for today’s office towers, apartment complexes, bridges, dams and airports. US cement production peaked in 2005 at 128 million tons. Between 2018 and 2019 China produced 4.4 billion tons, almost as much as America during the entire 20^th century.

There are no plausible, scalable methods to produce these four materials without the use of traditional energy. Fears that the energy transition would result in stranded assets of crude oil, gas and related infrastructure glossed over these vital inputs of modern civilization. Much of the growth in energy demand from emerging countries is aimed at building modern cities that emulate OECD countries.

This was always true even when ESG fervor was at its peak, inducing institutional disinvestment spurred on by that tiresome teenager Greta (“How dare you”). Energy reality is returning, rewarding those who relied more on analysis by Vaclav Smil than Climate Czar John Kerry. How appropriate that your blogger composed this on a flight to Houston.

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

Even After A 30% One Year Return, Pipelines Remain Cheap

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When the MLP structure dominated midstream energy infrastructure almost a decade ago, yield was a popular valuation metric. MLPs typically paid out 90% or more (sometimes over 100%) of their Distributable Cash Flow (DCF). Comparing MLP yields with the ten year treasury provided a measure of historic valuation.

By this metric, midstream isn’t cheap. The MLP spread is 0.20% narrower than 25 year average.

But much has changed for the sector in recent years. C-corps are the prevailing corporate form. Financial discipline has returned after the profligacy of a few during the Shale Revolution. Growth capex has declined, helped by opposition from climate extremists (hug one and offer a drive) whose success in stalling projects has given pipeline companies one less thing to do with their cash. It’s also increased the value of existing infrastructure. More recently, war in Europe has made energy security a political objective for the first time in living memory.

Midstream corporations tend to have lower yields than MLPs but have maintained dividends more reliably. MLP payouts have slid by almost half over the past eight years. There remains a valuation discount in retaining the MLP structure. Enterprise Products Partners, one of the best run MLPs, still yields 6.6% even though they maintained their distribution through the five year bear market that climaxed with Covid in 2020.

It’s also worth noting that, although sector indices show March 2020 was the lowest the sector has traded, c-corp yields never reached the highs of the 2008 financial crisis. We have often noted that forced selling by recklessly leveraged MLP closed end funds created the Covid low of 2020 (see MLP Closed End Funds – Masters Of Value Destruction). The chart of c-corp yields is another piece of evidence in support of our view.

Using Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA), the midstream sector is substantially cheaper than its average over the past decade. It’s also worth noting that today’s 10.2X multiple is barely changed from a year ago, even though the American Energy Independence Index (AEITR) has returned 38% since May 2021. The sector’s performance has tracked EBITDA growth.

The pipeline sector is historically cheap versus utilities, often a point of comparison.

If the pipeline sector’s EV/EBITDA widens towards its ten year average of 12.5, this would trigger meaningful price appreciation. With the typical company funding about half its operations with debt, a 20% appreciation in enterprise value would translate into a 40% increase in equity. If such an adjustment took place over five years, this would imply an annual 7% capital appreciation. Add in a 5% dividend yield and you get a 12% total annual return over several years.

When investors ask us about our outlook for returns, this is the type of math we run through. The price history creates concern for some potential investors that after such a strong rally another drop is coming. But the math of valuations along with the evidence noted above that MLP closed end funds caused more trouble than they’re worth ought to assuage such worries.

The capital allocation chart should provide further comfort about the pipeline sector’s long run prospects. Wells Fargo is projecting a 2.5% growth rate for dividends, and a 4X jump in buybacks. Capex is expected to stay flat, with roughly half dedicated to maintaining existing infrastructure (“sustaining capex”) and the balance for new growth projects. US energy executives show little inclination to push up spending initiatives. They recognize how fickle public policy is.

Democrats’ concern about gasoline prices has leavened somewhat their hostility to traditional energy – but few believe it’s anything more than political tactics prior to the midterms. Multi-year capital investments in oil, gas and related infrastructure still come with a highly uncertain IRR.

The 2.5% dividend growth rate can be added to the 12% projected return derived above. This is why a mid-teens, 14-15% pa total return is a reasonable bet even after recent strong performance. The AEITR’s long term returns versus the market no longer reflect substantial underperformance. Over the past one, two and three years pipelines have beaten the market. A few good days will make that true over the past five years as well.

Meanwhile Russia’s invasion of Ukraine can never be undone. Global energy trade is transitioning to reflect geopolitical and national security objectives, not simply commercial ones. Most countries either have energy independence or have no hope of attaining it. America is exceptional, in that we achieved it. US natural gas stands poised to provide secure energy supplies that often displace coal. The sector continues to offer fine prospects.

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

Fossil Future

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Alex Epstein’s 100K Twitter followers have anticipated for months the publication of Fossil Future – Why Global Human Flourishing Requires More Oil, Coal, and Natural Gas – Not Less. Few authors have promoted a book more relentlessly. I awaited its publication eagerly. It is the follow up to Epstein’s 2014 book, The Moral Case for Fossil Fuels.

Epstein’s chief insight, articulated in his first book, is that the standard by which fossil fuels should be judged is whether they promote “human flourishing.” He constructs an intellectual framework based on Utilitarianism that seeks the maximum benefit for the greatest number. If his first book built a moral case defending fossil fuels, his new one unapologetically celebrates their enormous positive impact on humans all over the world.

Epstein takes the offensive against environmentalists such as Bill McKibben, the Sierra Club, and other opponents of progress (“anti-humanists”) whose philosophy logically leads to lower living standards, pain, suffering and death for millions of people around the world.

When I read The Moral Case in 2017 (see review here) I found Epstein’s defense highly compelling. The strength of Utilitarianism is that it’s hard to argue against it. Maximizing benefit for the greatest number is the ethos of any civilization – when moderated to avoid imposing undue hardship on minority groups it is the most ethical set of rules to live by. Epstein is a philosopher not a scientist, so presses his case in these terms supported by familiar statistics.

Global CO2 emissions have risen in the last century along with the human population, life expectancy and living standards. It is axiomatic that the combustion of coal, oil and gas has made this possible. Western living standards would otherwise be unrecognizable. In emerging countries cheap energy provides basic needs to ever more people. Hundreds of millions have climbed up Maslow’s Hierarchy of Needs, able to access and move beyond the basic necessities of food, water, shelter and security.

Therefore, the moral case for fossil fuels is fundamentally about allowing non-OECD countries to improve their standard of living, education, health outcomes and longevity. Rich world energy consumption is roughly flat over the past decade. Even if we engineered a draconian reduction in CO2 emissions we wouldn’t offset the increases coming from China, India and others.

Ethically there’s no case for the US, EU and other rich countries to seek lower emissions from emerging economies. Practically speaking, these countries are in any event choosing growth and offering climate pledges barely sufficient to placate. Without foreign aid on a scale never given before, CO2 emissions will rise. Net Zero is an impossible goal.

Cheap (ie fossil fuel) energy aids farming through the use of equipment and irrigation. More efficient farming frees workers to produce other goods and services. Greater specialization further raises incomes, allowing the next generation to spend more time in school.

Construction equipment allows people to move from hand-built mud huts to more permanent, secure structures, leaving them safer. By replacing wood and dung, the choice of fuel for the poorest, coal oil and gas improve indoor air quality for millions of people.

Hospitals benefit from reliable electricity, better able to support a premature baby in an incubator and provide myriad other services that keep people alive.

Cheap energy supports air conditioning, the invention of which drew internal migration to the American south after WWII. Clean water requires energy to produce it. Piping clean water to homes takes energy. The list is almost infinite.

In western countries energy consumption is stable, and we’re no longer experiencing dramatic benefits from increasing its use.

In England in the 1800s, the average family spent 80% of its income on food. On the American frontier, the typical household burned 350 pounds of wood every day to keep warm and cook. OECD countries began their energy-related great improvement in quality of life in around 1850, the start of the industrial revolution and the benchmark against which today’s global temperature is compared.

Vaclav Smil, a multi-discipliniary scientist and prolific author, recently published How the World Really Works: The Science Behind How We Got Here and Where We’re Going. Smil estimates that coal provided half of England’s household heating as early as 1620, way ahead of the rest of the world which he estimates was still 98% reliant on plant fuels (ie firewood) for heat and light in 1800. By 1900 half the world’s primary energy came from fossil fuels (mostly coal, some crude oil).

Emerging countries are following the same path, regularly crossing inflection  points that improve their citizens’ lives.

Epstein is no climate denier. He simply argues that any evaluation of fossil fuels needs to consider the enormous benefits and not just the costs. China, India and other non-OECD countries are understandably pursuing what the west already has. And they’re consuming lots more energy in the process.

Media reports of increased extreme weather omit that weather-related deaths have fallen 99% in the last hundred years. Structures are more secure, and satellite-aided weather forecasts warn of approaching hurricanes. In fact, global computing and communications consumes the equivalent of 3 billion barrels of oil per year, more than global aviation.

As regular readers of this blog know, we long ago concluded that intermittent solar and wind will never be able to replace traditional energy. Places like Germany and California that rely more heavily on sun and wind power have much higher electricity prices. Fossil fuels still provide 84% of the world’s primary energy, down from 86% in 2000.

The most strident opponents of today’s energy mix deserve the anti-humanist label Epstein gives them. They have no answer to the moral question of why poorer countries shouldn’t strive to improve their lives. McKibben, the Sierra Club and US Climate Czar John Kerry sit at the top of Maslow’s Pyramid, with all their needs solved.

Epstein coins some memorable phrases. We’re taught that impacting nature is immoral, whereas fossil fuels have allowed us to make an environmentally hostile planet habitable, via robust homes, heat and clothing. As a result, humans have perfected “climate mastery.”

Epstein regards climate extremists such a McKibben as promoting “a murderous anti-impact framework.” Their policies would consign millions to misery and death.

The IPCC’s recommendations to prevent a 1.5 degrees C temperature increase from 1850 by 2050 are really aimed at preventing a 0.4 degree increase from now, because we’ve already experienced 1.1 degrees. Epstein believes the risks from climate change are manageable, and we should deal with them as they present themselves. He cites the inaccuracy of past projections as a basis for this.

Here’s where we differ. The science is better today. Climate is complicated to model, but the uncertainty includes possible downside scenarios. Prudent risk management requires that we take steps to reduce CO2 emissions. His explanation for why the overwhelming scientific consensus recommends CO2 reductions rests weakly on the need of scientists to obtain research grants and a bias by funding organizations to promote a consensus view.

The moral case for energy use doesn’t mean ignoring the low probability catastrophic outcomes. Being ethically right doesn’t guarantee human flourishing.

But we agree that prevailing wisdom places unreasonable confidence on forecasts of climate catastrophe, without allowance for high degrees of uncertanty and humankinds’ history of climate adaptation.

Phasing out coal in favor of natural gas and increasing our use of nuclear power are both powerful options staunchly opposed by climate extremists. Solar and wind can be part of the solution, but their embrace by purists as the complete answer is sidelining pragmatic choices like natural gas.

The continued growth of emissions by most non-OECD countries shows that, while most are taking steps towards IPCC goals, Zero by Fifty is highly unlikely. China, India and others long ago embraced Epstein’s philosophy. For them it’s the rational approach.

Epstein asserts that, “Fossil fuels have taken an unnaturally dirty world and made it clean.” Elsewhere, he adds, “Fossil fuels make our world unnaturally, amazingly, increasingly livable.”

Today’s energy has made today possible. We shouldn’t be apologizing for that. And natural gas can be the world’s biggest source of reduced emissions, by displacing coal, as it has in America.

Fossil Future provides a moral underpinning for today’s investors in reliable energy.

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

Please see important Legal Disclosures.