Offering investments tailored to ESG (Environmental, Social and Governance) criteria is a growing source of fee income for Wall Street. Morningstar calculates that 65 US funds have been repackaged into ESG funds since the beginning of 2019. Investors are attracted by the notion of holding virtuous stocks, but companies and fund managers must also find the flexibility around what constitutes an ESG-eligible stock to be appealing too.

A year ago we looked at the then-largest ESG ETF, the iShares ESG Aware MSCI USA ETF (ESGU), which had $15BN in AUM (see Pipelines Are ESG). ESGU looks so much like the S&P500 that their returns are 0.99 correlated.

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In the past year, ESGU has lagged the S&P500 by 2.5%. This underperformance has come just as the concept is coming under fire. Tesla (which is in ESGU) was dropped from S&P’s ESG index, prompting CEO Elon Musk to tweet that “ESG is a scam. It has been weaponized by phony social justice warriors.”

Musk is right that it’s a scam, although he hadn’t been a vocal critic until recently. Tesla was dropped even though its “ESG score” was stable, because its sector peers improved theirs. S&P explained that it’s not enough to be “taking fuel-powered cars off the road.”

Tesla drivers are passionate owners, but many overlook that 61% of US electricity generation is from fossil fuels, including coal (22%). It varies by state, but buyers of electric vehicles in Kentucky, West Virginia and Wyoming where coal dominates electricity production (69%, 88% and 80% respectively) are generating more harmful emissions than if they bought a conventional car.

Tesla was the biggest company to be dropped, but others included Berkshire Hathaway and Johnson and Johnson. Wells Fargo was dropped for being non-compliant with the United Nations Global Compact, which says it’s “the world’s largest corporate sustainability initiative”.

HSBC’s head of responsible investing, Stuart Kirk, may have given his swansong by accusing policymakers of overstating the financial risks of climate change. In a delightfully incongruous presentation at the FT’s Moral Money Europe Conference, he said, “there was always some nut job telling me about the end of the world.” His message was a rejection of the orthodoxy which often lapses into hyperbolic predictions that life as we know it is in its final decade.

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Kirk notes that the projections of economic loss are inconsequential. The UN’s IPCC report estimates as much as a 5% loss of global GDP by 2100 due to climate change. This is a trivial impact given that even 2.5% annual growth by then will leave the economy 6.86X bigger than it is today. If it’s only 6.52X bigger instead, few will care. It’s the difference between annual growth of 2.5% and 2.433%. Global stock markets aren’t visibly affected by the jump in news articles mentioning “climate catastrophe”.

Kirk is obviously ready for a career change. He complained about the inordinate time he spends with regulators discussing HSBC’s climate exposure, when he sees much more immediate threats such as cybercrime, inflation and pandemics. He has been suspended pending an internal review. Stuart Kirk will likely become a hero to those who believe that adaptation to a warmer planet deserves more attention than it receives.

ESG is being exposed as the emperor with no clothes. The SEC is about to crack down on misleading ESG investment claims by fund managers. SEC chair Gary Gensler said “It is easy to tell if milk is fat free. It might be time to make it easier to tell whether a fund is really what they say they are.”

Gensler might care to examine the Dow Jones Sustainability North America Index, whose owners display a sense of humor by continuing to include defense contractors Lockheed Martin and Northrop Grumman as constituents.

The main problem with ESG is its infinite malleability. ESGU, which now has $23BN in AUM, includes almost the entire S&P500. If everything is ESG, then nothing is. There is no clear differentiating feature. It’s been taken over by index providers and fund managers who have identified the profit potential in creating virtue-signaling investment products. ESG’s most important quality has been in attracting fund flows, which used to cause modest outperformance until the last year or so.

Unlike Dow Jones, ESGU doesn’t regard defense contractors as promoting sustainability, one reason why it’s been lagging the S&P500. However, it does include midstream energy infrastructure companies such as Kinder Morgan and Oneok. Cheniere is an addition since our last review of ESGU a year ago, but they have inexplicably dropped Williams Companies.

The Energy Information Administration tells us that biggest driver of America’s falling CO2 emissions has been switching power generation from coal to natural gas. Pipeline companies and Cheniere are doing more to keep the planet sustainable than any other company we can think of.

Elon Musk and Stuart Kirk are only the latest to challenge groupthink that has determined orthodoxy on climate change and the definition of doing good. There should be more to come.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The continued rally in the energy sector is steadily lifting past performance ahead of the S&P500 over multiple timeframes. The American Energy Independence Index (AEITR) now has a higher annual return than the S&P500 over the past one, two and three years. Even over five years the performance gap is closing. The 12.3% pa return on the S&P500 is 3.1% ahead of the AEITR. On the Covid low (3/18/20), the AEITR five year trailing return was –19.2% pa, 23.9% worse than the S&P500. It was a dark moment indeed for pipeline investors, and especially so for those focused on MLPs where the carnage was even worse. 

The subsequent recovery has produced some striking relative performance. The one and two year trailing performance figures cause some potential investors to question whether such a move will assuredly be followed by a collapse.  

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The fundamentals remain very good. 1Q22 earnings generally beat expectations, in some cases (ie Cheniere) by a huge margin. Financial discipline continues to constrain growth capex, aided by pipeline protesters whose efforts further dissuade spending on new projects. Hug a protester and offer to drive them somewhere. 

The Covid recession and recovery dominate recent performance history. But it’s worth remembering that the pipeline industry had already shifted away from spending for growth in favor of increasing free cash flow before that. By late 2019, pre-Covid, we felt the sector was poised to outperform because the growth years and MLP distribution cuts of the Shale Revolution had alienated so many investors.  

Two months ago, the pre-Covid return (ie from 12/31/2019) on the AEITR moved ahead of the S&P500. As of Thursday, the AEITR is 8.3% ahead of the market. Surging inflation and Europe’s sudden desire for energy security are two important tailwinds for energy stocks. But the sharp drop and quick recovery that Covid inflicted on the pipeline sector is looking increasingly aberrant. It will always be part of the sector’s history. Becoming comfortable that it won’t repeat is a hurdle facing many potential new investors.  

Closed End Funds (CEFs) have a longer history of providing MLP exposure to retail clients than even the deeply flawed Alerian MLP ETF (AMLP, see MLP Funds Made for Uncle Sam). For example, the Cushing MLP & Infrastructure Total Return Fund (SRV) sports an inglorious fifteen year history of relentless capital destruction. It now trades at less than one tenth of its IPO price. In 2015 we were moved to note its sorry eight year performance of delivering less than a quarter of the return of its benchmark (see An Apocalyptic Fund Story). Although consistent performance has rendered its diminutive size ($70 million AUM) no longer a significant source of revenue to manager Swank Energy Income Advisers, it still serves to warn CEF investors of the damage leverage and poor management can inflict.  

CEFs were generally not a big factor in the Covid bear market, but they did play an outsized role in the MLP collapse, which hurt the entire midstream sector. Operating a single sector fund with leverage reflects an opinion that the companies in that sector should be operating with more debt than they currently do. In effect, it’s a rejection of the collective wisdom of all the CFOs and rating agencies that have arrived at the prevailing capital structure in use.  

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Since the stocks within a sector will tend to be highly correlated with one another, there’s little diversification benefit which might otherwise justify the increased risk profile. Single sector closed end funds use leverage to increase the dividend they can pay. But maintaining that leverage requires them to add to their holdings in a rising market – and to reduce them in a falling one. 

When MLP prices collapsed in March of 2020, MLP CEFs had no choice but to delever, which required selling. They exacerbated the fall in prices for the pipeline sector.  

The reason investors shouldn’t expect a repeat is because the consequent value destruction left all the MLP CEFs smaller. They’re no longer managing as much money, because of locked in losses, so wouldn’t have as much to sell even if we endured a repeat of March 2020. The managers of sector-specific CEFs with leverage combine poor judgment with hubris. They include Goldman Sachs, Tortoise, First Trust and Swank.  

Many MLP CEF holders who hung on in the belief that what falls so far must surely rebound will have been disappointed. The 17 MLP CEFs listed on Nuveen’s website are on average still down 37% from their level at the end of 2019, pre-Covid. The AEITR has fully recovered its losses with an 18.5% pa positive return. 

The two lessons are: (1) don’t invest in single sector CEFs because the leverage will eventually create permanent losses, and (2) because MLP CEFs provided evidence of #1 in 2020, they can’t repeat. So prospective investors in midstream energy infrastructure can regard the worst of the March 2020 brief collapse in pipeline stocks as unlikely to repeat.  

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Last week’s Economist magazine included an illuminating op-ed by Nigeria’s vice-president on “the hypocrisy of rich countries’ climate policies.” Like most emerging countries, Nigeria is simultaneously pursuing two goals; improving the access of Nigerians to energy, while reducing the country’s Greenhouse Gas (GHG) emissions.

Vice-president Yemi Osinbajo’s essay neatly captures the dilemma his and other governments face. He wants to “close the global energy inequality gap.” He noted that the 48 sub-Saharan countries of Africa (excluding South Africa) are home to a billion people and use less electricity than Spain’s population of 47 million. Osinbajo wants Nigeria to achieve annual power output of at least 1,000 kilowatt hours per person. Today per capita electricity consumption in Nigeria is less than a fifth of this goal. With the country’s population of 206 million expected to double by 2050, the vice-president estimates electricity output will need to increase by 15X.

Dramatically increasing domestic power generation is a popular message designed to resonate with Nigerian voters. That part of Osinbajo’s essay is targeted at his domestic audience. Then he turns to his audience of foreign OECD governments, noting that Nigerian president Buhari has “pledged that Nigeria will reach net-zero emissions by 2060.”

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ClimateActionTracker.org estimates that Nigeria’s GHG emissions will increase by 21% over the next decade. The “Almost Sufficient” grade is generous since they’re set to increase faster than ever.

Climate change is not big concern among Nigerians. Last year the Yale Program on Climate Change Communication found that Nigeria polled dead last out of 31 countries on knowledge of the topic, with only 26% responding that they knew “a lot” or “a moderate amount” about it. The US equivalent was 71%. Only 58% of Nigerians were “very or somewhat” worried, close to the US at 68% and far behind Mexico (95%). That Nigerians and Americans are similarly worried about climate change is ironic because the US, with a per capita GDP 10X Nigeria’s, is far better able to pay for mitigation.

The result is that Nigeria, like many other poor countries, offers very different messaging depending on its audience. Domestically they prioritize raising living standards, which includes access to electricity. Internationally they offer solemn pledges to reduce GHG emissions.

The COP26 meeting in Glasgow last year pledged $8.5BN to South Africa to accelerate their energy transition, although it’s still unclear how or when this will be funded. Nigeria believes it needs a green package of $10BN per year over two decades, which will cover half the capital required to meet its net-zero pledge. Plainly, Nigeria won’t reduce emissions without substantial financial support from the US and other rich world countries.

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Nigeria’s power sector generates about 12 million tonnes of CO2 equivalent, less than one per cent of the US at just over 1.5 billion tonnes.  If Nigeria’s goal of adding 15X more output was done with the same energy sources, it would add what 25 million Americans generate. It sounds modest. But applied across the rest of the non-OECD world and not limited to just the power sector, growth in emerging economies could easily offset whatever reductions the rich world can achieve.

There’s a moral argument that the OECD countries who have used up most of the atmosphere’s assumed capacity for CO2 should cut their emissions aggressively while paying non-OECD countries to curb theirs. It’s a complicated issue. We’ll never subsidize China’s investments in clean energy. Moreover, western countries didn’t impose half a century of growth-impeding socialism on China or India, which they only began to shed in the 1990s. Both are making up for lost time, which is why their living standards are catching up. China is now the world’s biggest emitter, spewing out 2X the US which is number two. India is third. The world’s climate will be determined by China, India and other emerging countries.

The challenges are simple to articulate, if complex to solve. Poor countries are both more vulnerable to the negative effects of a warmer planet, and less motivated to tackle the issue without substantial OECD financial and technological help. Without a massive commitment, the world will learn to adapt to increased levels of CO2 in the atmosphere.

US climate extremists have successfully forced New England to import liquefied natural gas by, for example, blocking new pipelines from Pennsylvania. Their conviction that such efforts somehow address the non-OECD challenge outlined above betrays a misunderstanding that would be comical if it didn’t have as its objective condemning Americans to cold and darkness. It’s exacerbated by President Biden’s promise to, “…deploy clean energy for the benefit of all Americans—with lower costs for families, good-paying jobs for workers.”

US political leaders steer so far from confronting the issues, including higher costs and substantial foreign aid, that they’re encouraging wholly unrealistic and inadequate policy responses. This is why global demand for natural gas will continue to grow. Like western politicians, Nigeria’s v-p is tailoring his message to his audience.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Financial advisors probably feel that they’re more than earning their pay recently. Market volatility is high, which means clients want to know what’s going on. Advisors have in the past confided to me that one of their most important roles is to persuade clients from selling impetuously. Their original asset allocation was made after much careful consideration and ought not to be tinkered with just because the market’s moved a bit. Friday’s rally helped, but the S&P500 is still -15% for the year. If you have energy exposure, you’ll have done better.

Global stocks registered their sixth straight weekly decline, the longest streak since 2008. This is a testing environment for financial advisors.

By contrast, Fed chair Jay Powell can look back at the ten days following the last FOMC meeting, 0.50% rate hike and press conference with some satisfaction. Investors won’t hear it said this way but engineering an orderly fall in stock prices is one of the Fed’s goals. Former NY Fed president Bill Dudley, no longer burdened by the requirement to speak responsibly as a senior Fed official, has warned that the Fed’s going to tighten financial conditions enough to push up the unemployment rate (see Criticism Of The Fed Goes Mainstream).

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The Fed’s reinterpreted mandate places greater importance on achieving maximum employment. Powell hasn’t offered any warnings that unemployment needs to rise. In a fascinating excerpt from his press conference, he noted that job openings were equal to almost twice the number of unemployed, and said they were trying to reduce this imbalance. A perfect outcome for the Fed would see a drop in job openings without a commensurate increase in unemployment, making possible the vaunted “soft landing”.

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When you also consider the FOMC’s Summary of Economic Projections expecting unemployment to remain at 3.6% through 2024, this is further evidence that they are prioritizing continued full employment. They’ve been criticized for this by Larry Summers among others, because it seems inconsistent with simultaneously reducing inflation to 2.3% over the same time period.

The bond market became a little more convinced that the Fed will pull this off. Although the CPI and PPI reports showed prices continue rising at a fast clip, ten year inflation expectations derived from TIPs dipped to 2.74%, having recently touched 3%. Since CPI, which is the index TIPs follow, typically runs 0.3-0.4% higher than the Fed’s preferred Personal Consumption Expenditures index, they can plausibly conclude that investors are buying the narrative that inflation will return to 2% within a couple of years.

It doesn’t look like a good bet to us. The FOMC is dovish. The disinflationary effects of globalization are petering out. And the US fiscal outlook requires higher inflation so that negative real rates can ease the burden of our growing debt.

Moderating inflation expectations have caused the twos/tens spread to widen and moderated the inversion that exists in part of the eurodollar futures curve. An inverted yield curve is a forecast from the market of a looming failure of monetary policy, implying an overshoot in tightening that would require it to be reversed.

Hoping that reduced job openings will be sufficient to cool the economy, as Powell seemed to suggest during his press conference, seems wildly optimistic with no historical precedent. Raising rates beyond the 2-3% range the FOMC believes is neutral seems certain to require a pause to assess whether prior hikes are already having an effect.

At his press conference Powell explained, “So what that really means is, to get the kind of labor market we really want to get, we really want to have a labor market that serves all Americans, especially the people in the lower income part of the distribution, especially them.” This is a laudable public policy objective, if a dubious addition to the Fed’s objectives. Monetary policy is notoriously slow and blind to the individuals it impacts. Hence the eurodollar futures curve should be priced for cautious rate hikes next year that lower the odds of requiring a reversal.

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I was chatting with an investor on Friday about the increasing incidence of 1% daily moves in the S&P500. Such moves are now more likely than not based on the past 100 trading days (see Pipelines Are Less Volatile Than You Think). He found it an interesting way to think about volatility, one that’s easily intuitive. Such 100 day regimes have existed only 8% of the time over the past quarter century.

Daily moves greater than 0.5% currently occur 70% of the time. 100 day periods like this have existed less than a fifth of the time.

2% daily moves remain uncommon but are creeping up, currently 15% of the last 100 trading days (including the 3.2% drop on Monday 9^th).

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Even if increased volatility doesn’t lead to lower stock prices, it probably tempers exuberant economic activity. The University of Michigan’s consumer sentiment survey registered its lowest reading since 2013, with inflation cited as the biggest area of concern. Long term inflation expectations remained at 3%, slightly above the rate derived from ten year treasury securities.

In sum, lower stock prices, a steepening yield curve and falling long term inflation expectations are a positive grade on the FOMC’s report card. Investors may not feel quite as sanguine after another volatile week, but Jay Powell might permit himself a moment of quiet satisfaction.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

If it feels like the market’s daily swings are giving you whiplash, you’re right. Following Monday’s rout, the number of daily moves in excess of 1% breached 50% over the past hundred days. In other words, a 1% or greater change in the S&P500 is now more likely than not.

This is unusual. Markets were remarkably calm in the second half of last year. Volatility picked up towards year end as it became clear the Fed was way behind in normalizing policy. Nonetheless, such periods are rare. In the last quarter century such regimes have only existed for 8% of the time. Oddly, this doesn’t augur poor returns. For example, in April 2020 market volatility crossed that “more likely than not” threshold and the subsequent one year return was almost 50%.

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However, it does mean advisors will spend more time discussing the outlook with clients. Inflation, an unexpected war in Europe and China’s vain attempt to stamp out Covid are significant headwinds. Recession risks in Europe are rising too. Germany is scrambling to overcome its reliance on Russian natural gas. They are under increasing pressure to unilaterally stop imports, which would likely plunge Germany into a recession, and partial darkness.

Chancellor Olaf Scholz recently said, “It doesn’t help anyone if the lights go out here. Not us and not Ukraine,” But who really expects Russian gas to keep flowing reliably up until the moment Germany closes Nordstream One? Ending Russian gas supply is likely to be timed to suit Russia not Germany. Russia’s infrastructure precludes quickly rerouting their gas to Asia. A move that’s intended to harm Russia is unlikely to be implemented on Germany’s timeframe. So it’s probably going to be disruptive.

Value sectors including energy have returned with a vengeance. Bloomberg calculated that Cathie Wood’s ARK Innovation ETF (ARKK) has now underperformed the S&P500 since its launch in October 2014. Early this year ARKK crossed another ignominious threshold when we showed how poor has been the typical ARKK holder’s experience (see ARKK’s Investors Have In Aggregate Lost Money). ARKK’s since inception performance has not yet been exceeded by the American Energy Independence Index (AEITR), but rest assured that we shall note such in a future blog post if it occurs.

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The AEITR did reach another milestone though – from the index inception date on 12/29/2010, it has now outperformed the S&P500. For most of the past decade investing in pipelines looked like a reliable way to lag the market. Regular readers know our confidence in midstream energy infrastructure has never been swayed by returns that at times presented powerful evidence of misplaced optimism. Ample history showing we have no skill at market timing means we’re still bullish on the sector – to us the reasons are abundant, just as the supply of reliable energy is constrained. Energy investors were cheered by Saudi oil minister Prince Abdulaziz bin Salman’s comment that, “The world needs to wake up to an existing reality. The world is running out of energy capacity at all levels.” I’m the driver you see smiling at the gas pump.

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The pipeline sector is not only beating the S&P500. It’s also moving less. By the “more likely than not to move 1% or more” definition, the AEITR has the edge over the S&P500. This has rarely been the case over the past decade. The capital profligacy of the Shale Revolution caused volatility up and then down. Energy transition fears and Covid heaped further uncertainty. But they’ve been replaced by financial discipline, energy realism and the end of Covid (other than in China).

First quarter pipeline company earnings were very good, with most big companies beating expectations. Natural gas exports are creating more opportunities. Energy Transfer expects to move ahead with their Lake Charles liquefaction facility by the end of the year (see High-Energy Earnings Boost Pipelines). Even conservatively run Enbridge expects to profit from growing global demand for US natural gas. CEO Al Monaco recently said, “LNG exports are a big opportunity, with momentum building across the U.S. Gulf Coast, and now more so in western Canada.”

North American midstream energy infrastructure is steadily making up for lost ground over many timeframes. It’s doing so with no more volatility than the market, and in recent months has provided a very welcome negative correlation with traditional stock/bond portfolios. It’s worth noting that recession fears have had only a muted effect on energy prices. Crude oil is still around $100 and the Asian JKM benchmark for natural gas is at $27 per million BTUs for next winter, more than triple the US Henry Hub price. We continue to believe the pipeline sector offers attractive return potential to the long term investor.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Earnings for pipeline companies are generally devoid of excitement unless steady growth gets you animated, such is the stability of most business models. But 1Q22 earnings were full of positive surprises. Cheniere (CEI) blew away expectations with 1Q22 EBITDA 65% ahead of consensus. Most of their Liquefied Natural Gas (LNG) contracts are based on a fixed charge for liquefaction, but in some cases they’re able to market the LNG themselves.

Continued strength in global LNG prices drove the beat. CFO Zach Davis reported that because of cash flows, “We’ll be bringing down the share count. We’ll be reducing interest expense, and ideally, eventually yes, increasing that guidance, but we’ll stick with what we got today.” He was referring to long term guidance, because they increased their 2022 EBITDA and Distributable Cash Flow (DCF) guidance by 17% and 26% respectively.

Enbridge (ENB), North America’s biggest pipeline company, beat consensus EBITDA by 2.2% and raised their dividend by 3.3% year-on-year. Dividend hikes are becoming a common theme across the sector. ENB has one of the more conservative management teams in the industry. Their C$3.44 per share payout equates to a generous 5.9% yield, 1.75X covered by DCF. ENB is also growing their energy transition footprint. They announced plans to develop a Carbon Capture and Sequestration (CCS) hub in Alberta, to capture CO2 emissions from local power generation and cement production. Like most of the big pipeline stocks, it still looks cheap to us.

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Energy Transfer (ET), widely held by financial advisors we talk to, beat EBITDA expectations by 13% largely due to strong performance in natural gas pipelines. Co-CEO Marshall McCrea said on their earnings call, “In this quarter, our intrastate volumes were up 17%. Our interstate volumes were up 15%, our midstream volumes were up 14%. Our NGL’s record volumes, as I alluded to earlier, were up 17%.”

ET also expect to make a Final Investment Decision (FID) on their planned Lake Charles LNG export facility soon, having signed several agreement with buyers recently. McCrea saying, “we’re highly optimistic that we’ll have this fully contracted by the end of the year.”

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Earnings beats and improved guidance were common, delivered by Kinder Morgan (KMI), TC Energy (TRP), Enterprise Products (EPD) and Williams (WMB) among others. Strength in natural gas pricing and volumes was widespread. Like ET, EPD saw strong demand in its Natural Gas Liquids (NGLs) segment where EBITDA of $1.2BN was 15% ahead of consensus.

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The US moved to a net exporter of NGLs in 2010 and now ships 2.3 Million Barrels per Day (MMB/D). Propane, widely used in home barbecues and by farmers to dry crops, is over half this. EPD, ET and Targa Resources (TRGP) dominate the processing and movement of NGLs.

TRP raised growth capex by 9% and attributed it all to inflationary pressures on labor and materials, something we’re all accustomed to. Meanwhile Equitrans (ETRN) continued to press ahead with the Mountain Valley Pipeline (MVP), buoyed no doubt by vocal support from Senator Joe Manchin (D-WVa). MVP is all but complete, but has suffered repeated delays because of adverse court rulings on previously issued permits.

ETRN is now pursuing new permits from two Federal agencies and hopes to place MVP into service by 2H23. NextEra, a JV partner in MVP, was so pessimistic on MVP’s prospects that they wrote their investment down to zero in February. Their shrewd accountants have engineered a tax deduction on the full capital investment with the possibility of future returns on an asset carried at zero.

Since KMI kicked off pipeline sector earnings on April 25^th, the American Energy Independence index (AEITR) has gained 3.5%, outperforming the S&P500 by 7.5%.

Fears of stranded assets due to the energy transition used to hang over the sector. Opposition to new pipelines from environmental extremists further contributed to negative investor sentiment. We concluded long ago that constraints on spending by pipeline companies was good for investors, albeit sadly not so good for consumers (see Partnering with Pipeline Protesters from June 2019). WMB CEO Alan Armstrong confirmed as much on their earnings call, when he said, “Thanks to the efforts of the environmental opposition and making pipeline permitting so difficult in the areas that we operate, it’s allowed us much higher returns in that space than would normally be allowed.” If you meet a pipeline protester, give them a hug and offer to drive them to their next event.

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Failures of European energy policy are boosting the outlook for our energy sector. Because climate extremists have held more influence than in the US, over the past two decades Europe let its domestic oil and gas production drop by half. Although consumption has been falling, their increasing reliance on Russian oil and gas made them more supplicant than trade partner. Abandonment of this policy is already boosting the results of pipeline companies and their improved outlook. The EU has held a strong, wrong opinion on energy. By contrast, WMB’s Armstrong said of the US, “I think all of us would question whether we’ve actually had an energy policy or not.” He’s right. No policy is still better than a bad one, but we can do better.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The ten year treasury yield touching 3% has drawn headlines, but the bigger story is that the increase in nominal yields has been driven by rising real yields. Ten year TIPs yield 0.18%, the first time they’ve been positive in over two years. Until recently, real yields had been declining irregularly for decades. $TNs of return-insensitive capital (central banks, sovereign wealth funds and others with inflexible investment mandates) is part of the reason.

The Fed needs tighter financial conditions in order to slow the economy. Higher real ten year yields help. Tighter monetary policy is most effective when it increases bond yields, because that’s where the economy and equity markets are more sensitive. Therefore, rising bond yields reduce the need for aggressive hikes in the Fed Funds rate.

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Criticism of the Fed has been limited. Former Treasury secretary Larry Summers and former NY Fed president Bill Dudley are notable exceptions, and are well qualified to find fault publicly, as they have. Republicans have voiced unhappiness about elevated inflation, while Democrats seem to care more about the Fed’s approach to climate change. We may not like inflation, but since the cure is a weaker economy, we’ll like that a lot less.

Quantitative Easing (QE) was obviously maintained way too long, and the Fed is approaching its opposite, Quantitative Tightening (QT), cautiously. Much has been made of their decision to shrink the balance sheet, but they have over $1TN in treasury securities maturing within the next year. Letting these roll off won’t impact ten year yields. But they may sell Mortgage Backed Securities (MBS), which looks sensible because buying Fed buying of MBS has been supporting the strong housing market.

The Fed remits its operating surplus to the US Treasury every year. In recent years this has been swollen by positive net interest income from its $9TN balance sheet.

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In its last fiscal year (ending September 2021) the Fed reported $122BN in interest income from securities. Its balance sheet averaged $8TN, so we can infer that the average interest rate on its portfolio is around 1.5%. After adjustments, net income of $107BN was remitted to the government.

The Fed’s FY2021 interest expense was $6BN, but this is now going up. Assuming the $1TN in securities that will mature within a year yield 0%, the remainder of the Fed’s balance sheet yields just over 1.7%. Short term rates will be at that level by year’s end if not sooner. The 2022-23 fiscal year will see a steep drop in the Fed’s annual remittance to the Treasury. It could even flip to where the Fed has an operating loss.

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Auctioning MBS would generate realized losses for the Fed. They have over $2.6TN in MBS with maturities of greater than ten years. Assuming a duration of ten and a 2% increase in yields from when they were bought, for every $100BN in MBS the Fed sells they’d realize a $20BN loss.

None of this will surprise policymakers, who we can assume took all this into consideration when they began the latest round of QE in 2020. They worried about their exit a decade ago, when wrestling with how to reduce their balance sheet following the 2008 Great Financial Crisis (GFC). Back then St. Louis Fed president James Bullard called it a “recipe for political problems.” They began tightening monetary policy in late 2015, and took almost four years to reach 2.4%. The Fed moved so slowly to unwind the GFC balance sheet that it wasn’t far below its 2016 $4.5TN peak before Covid led to a second round of QE. From 2015 to 2019 their remittances to the Treasury fell by almost half.

The Fed could argue that losses from QE are proof of its benefit. The higher rates that follow reflect QE’s success in arresting the economic decline that necessitated it. This is a sound economic argument, but not one that’s been tested yet. It’s the opposite of what deft currency intervention produces – a central bank that steps in to offset extreme moves in its currency is buying low/selling high – as long as it’s successful. Sometimes it isn’t. The 1992 collapse of Sterling against the Deutsche Mark overwhelmed the Bank of England, netting George Soros’s hedge fund an estimated $1BN profit on “Black Wednesday” (September 16, 1992).

QE is a buy high/sell low strategy. Because of the Fed’s error in maintaining overly accommodative policy for too long, they now must tighten more aggressively. It’ll take time, but the budgetary consequences of their poor decisions will reach the political classes in another year or so, in time for the 2024 presidential election. The Congressional Budget Office estimates that a 1% increase in rates above official projections increases the interest expense on Federal debt by $200BN. Their most recent forecast was for ten year treasury yields to average 1.6% through 2025.

Slower normalization of monetary policy and lethargic balance sheet reduction will allow higher inflation while smoothing the drop in Fed remittances to the Treasury. Such a debate won’t make it into the FOMC minutes, but will be on the minds of chair Jay Powell and his colleagues.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Last week recession questions were more common than in the past during our many conversations with clients. The likely performance of the energy sector during a slowdown is what they’re asking.

Recession risks are growing in the minds of many. In one recent survey, a third of economists are forecasting a recession within two years. Some may joke that a third of economists are always forecasting a recession – but Goldman Sachs puts the odds at about 35% and JPMorgan has increased provision for loan losses because their internal modeling showed heightened risk.

Recessions aren’t good for stocks, and no sector is immune. If you’re worried about a recession, you should reduce your equity holdings. But the market invariably bounces back – most spectacularly following Covid. The bigger risk for investors is inflation, and it may not always come with robust economic growth as we have now.

Data on Friday showed 1Q22 Eurozone growth of only 0.2%, down from 0.3% the prior quarter. France was flat and Italy contracted. Year-on-year inflation is running at 7.5%. Stagflation, which is being increasingly heard from European analysts, is especially hard for central banks to manage because the correct monetary stance is unclear.

The US is in better shape. Last week’s GDP report was negative partly due to a bigger trade deficit, evidence of robust demand. On Friday personal consumption expenditures were solid and the quarterly Employment Cost Index increased by 1.4%, up from 1.1% in December. In America, everyone who wants a job has one. Gasoline prices are high, but Democrats can promote that as a reason to accelerate the energy transition while Republicans can feel good about the boost this provides to domestic production and energy independence. Maybe I’m overly glass half full, but spending $100 to fill up feels pretty good right now.

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The Fed is forecasting a utopian combination of falling inflation, moderate rate hikes and continued strong employment that is so hopeful it’s certain to be wrong.

We looked back at the performance of Exxon Mobil (XOM) versus CPI going back to 1970 to see what type of inflation protection the energy sector might offer. It turns out that one year returns on XOM and year-on-year CPI aren’t correlated during times of low inflation, but the relationship is stronger when prices are rising faster. The chart plots both sets of one year returns from 1970 to 1982, the last time we had inflation as high as it is today.

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High returns on XOM anticipate higher CPI, although the time lag does seem to vary. When inflation is running above 6%, one year XOM returns have a 0.25 positive correlation with one year lagged CPI. In other words, when investors anticipate rising inflation, they invest in the energy sector ahead of time. The strong recent returns on energy stocks have similarly correlated well with higher inflation.

Which element of the FOMC’s utopian forecast is most likely to be wrong? It doesn’t even have the Fed Funds rate reaching inflation until the end of next year. A real policy rate that’s negative is not how monetary policy has in the past curbed inflation. It’s also unclear why wage inflation, currently 4.7% and rising year-on-year, will moderate if the unemployment rate remains at 3.5% as they expect.

The path to a recession runs through stubbornly high inflation. The last two downturns, 2020 Covid and 2008 Great Financial Crisis, were unusual. Most recessions occur because the Fed waits too long to raise rates and then goes too far. If those recession fears turn out to be prescient, it will most likely be because the Fed’s rate forecast was too benign. That would mean their inflation forecast was also too optimistic. This would in turn suggest that energy stocks would continue to play an important role in protecting against inflation.

In brief – if you fear a recession, you could do worse than buy energy stocks because it’ll be higher than expected inflation and interest rates that causes one.

On a separate note, Tellurian (TELL) CEO Charif Souki has many talents but deferred reward for good execution is not one of them. We’ve long preferred NextDecade (NEXT) over TELL – both are planning new export terminals for Liquefied Natural Gas (LNG), but Souki’s risk tolerance and inflated view of his own compensation have never sat well with us. When energy stocks cratered two years ago, Souki was forced to sell TELL stock he owned on margin. No matter – the board soon granted him more.

In a proxy quietly filed on Thursday (see here pg 69 paragraph c), TELL granted Souki over $17 million in stock awards. His payday ought to wait until TELL is actually loading LNG onto tankers from its not yet built terminal. TELL’s prospects look very good, but if the additional equity capital they assuredly need comes on terms that are ruinously dilutive for today’s common equity holders, their CEO will nonetheless have done very well. Souki is a risk factor for investors in TELL to consider.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The US was increasing its net exports of natural gas before Russia’s invasion of Ukraine added an element of urgency. Liquefied Natural Gas (LNG) gets most of the attention, but this year we’ll export nine Billion Cubic Feet per Day (BCF/D) by pipeline, to Mexico and eastern Canada.

LNG exports are still rising, with most global trade directed to Asia. Cheniere, whose Sabine Pass and Corpus Christi terminals export over half the total, often signs flexible contracts that give the buyer (typically a large trading firm like Trafigura) destination flexibility.

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As Europeans buyers have scrambled to replenish storage, they have outbid Asian buyers. Competition between the two is likely to intensify later in the year. Germany hopes to begin using the four floating LNG terminals they’ve leased as soon as this winter, assuming the land-based infrastructure can be ready in time. Global LNG prices are likely to remain firm.

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The difference between US natural gas prices and the two main overseas benchmarks remains huge – far more than necessary to induce higher exports which are limited by our LNG export capacity. As we send more LNG overseas, it will create some upward pressure on domestic prices. The good news is that domestic production is increasing to keep up with exports.

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The US Energy Information Administration (EIA) in their current Short Term Energy Outlook US expects coal consumption to decline next year after rising in 2022. Power plants switching from coal to natural gas will be the driver, as it was for over a decade prior to Covid. The EIA expects US natural gas prices to ease from today’s relatively high prices because of increased production. This will keep our energy-related CO2 emissions flat next year.

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Kinder Morgan (KMI) reported better than expected 1Q22 results last week, buoyed by their Natural Gas Pipelines segment. Growing natural gas takeaway capacity out of the Permian basin in west Texas is behind KMI’s decision to invest in more compression on their Permian Highway and Gulf Coast Express pipelines that run from west Texas to the Gulf of Mexico. Increasing capacity on existing pipelines is preferable to greenfield projects across most of the country. It heads off environmental extremists and requires less capex, so is preferable where existing infrastructure allows it.

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Energy Transfer (ET) is the individual name most often held by financial advisors we talk to. It has been consistently cheap, inexplicably so to many, for years even relative to a sector that has long been out of favor. This year it has been one of the leaders in the American Energy Independence Index (AEITR). Yesterday ET announced a 30% distribution hike, another step on the road to redemption for a company with a checkered history of fiduciary forgetfulness (see Energy Transfer: Cutting Your Payout, Not Mine).

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Clients who are underinvested in the pipeline sector often look at recent returns and ask whether they’ve missed the rally. Those possessed of sufficient fortitude or recklessness to have bought on March 18, 2020 are up 4X. Returns from the Covid low are spectacular, but highly aberrant. The YTD return at that point was –64%, caused in no small part by the managers of MLP closed end funds who combined poor judgment with misplaced self-confidence (see MLP Closed End Funds – Masters Of Value Destruction). It is to their clients’ misfortune but everyone else’s gain that sufficient capital was destroyed in the rush to delever that they’re now too small to repeat.

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A longer timeframe is more meaningful. Over four years, the AEITR has delivered almost the same return as the S&P500 (12.5% pa vs 14.0% pa). Another couple of days of relative performance like yesterday (S&P500 lagged AEITR by 2.5%) will make their four year returns match.

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An investor contemplating an equity allocation would scarcely be dissuaded by the stock market’s four year return. However, the prospects for inflation above the Fed’s 2% target for years might give her pause. Pipeline stocks should do well in such an environment.

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Or she may consider the growing importance of energy security to Europe and the resulting demand for US LNG; the continuing financial discipline exhibited by energy companies, and the global opportunity for reduced CO2 emissions from coal to gas switching.

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The point is that the traumatic V-shaped low of midstream energy infrastructure in 2020 creates high recent returns, but over longer periods pipeline sector returns look rather equity-like. Since December 2010, the inception of the AEITR, the S&P500 is ahead 13.3% vs 11.6%. The AEITR is 18% away from where its 12 year return would equal that of the S&P500, less than its YTD performance. We think it will close that gap too.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Earlier this month there was a fascinating exchange on Bloomberg TV between former NY Fed president Bill Dudley and journalist Jonathan Ferro. Dudley has been vocal in criticizing the slow rate at which his former FOMC colleagues have been normalizing monetary policy. He’s pointed to the robust stock market and warned that the Fed’s going to tighten financial conditions enough to push up the unemployment rate. Ferro, refreshed by the frank analysis and used to more guarded responses from Fed officials, asked Dudley “why Fed officials don’t talk like you?”

Dudley responded that it’s unpleasant to talk about how you have to push up the unemployment rate and put people out of work, even though that is the Fed’s goal.

The Fed wants tighter financial conditions. This needs to manifest itself via higher long term yields, since sectors like housing and capital spending are more sensitive to the ten year yield than the Fed Funds rate. And the Fed needs a weaker stock market, because households that feel poorer will spend less, cooling things down. It is truly an unpleasant prospect. Covid has receded other than a few remaining constraints – Broadway shows still require masks and travel outside the country may still leave you stranded if the required Covid test before re-entry is positive.

But with 3.6% unemployment the vast majority must be better off, and happier, than they will be once the Fed engineers tighter financial conditions and the consequent economic slowdown. On Thursday, Fed chair Jay Powell said, “It’s absolutely essential to restore price stability. Economies don’t work without price stability.”

Ten year yields are approaching 3%. Compared with 8.5% annual inflation Bill Dudley notes that policy remains very loose. But yields are edging up, helped by Fed officials warning of successive 0.50% rate hikes, as Powell did last week.

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The stock market isn’t helping much, even after last week’s sell-off. For the first time in a decade, the Equity Risk Premium (ERP) doesn’t make stocks look cheap. The 5.4% earnings yield, based on Factset bottom-up figures, versus a 2.9% ten year yield puts the ERP at 2.5, right on the average since 2000 when the dot.com bubble burst.

Earnings forecasts are being revised higher, reflecting little evidence of any influence from the Fed. Analysts still expect growth next year of 10%. But a 3.4% ten year yield in 2023 would be enough to keep the ERP at 2.5. By this measure, stocks are as expensive as they’ve been in the past decade. Tighter financial conditions include a weaker stock market according to Bill Dudley. If the stock market repriced to its average ERP of 3.3 over the past ten years, that would imply the S&P500 around 15%, lower.

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When a liberal-leaning magazine such as The Economist blames today’s inflation on the Democrats pushing through last year’s $1.9TN stimulus, you know it’s conventional wisdom. Larry Summers must be a thorn in the side of the White House, since he warned of such as the package was being debated and hasn’t let up since. This week’s Economist analyzes the Fed’s “historic mistake on inflation” and includes a special report on central banks. They blame the Fed’s modified interpretation of its mandate to allow higher inflation, along with institutional groupthink that assumed stable prices were hard-wired into the economy.

The Economist also notes that central banks have taken on a broader remit in recent years. In the US progressive Democrats wanted that to include policies to counter climate change. Fed candidate Sarah Bloom Raskin withdrew her nomination when Senate Republicans objected to her past comments pushing the Fed to withhold pandemic support from fossil fuel firms.

However, the Fed does now seek maximum employment that is “broad-based and inclusive”. Powell explained the shift thus: “This change reflects our appreciation for the benefits of a strong labor market, particularly for many low- and moderate-income communities,”

There is evidence that minority unemployment, which is always higher than for the general population, rises faster during a slowdown. This will be a consideration in the background when the FOMC is facing rising joblessness but has not yet conquered inflation. Debt:GDP is the most important reason America will learn to live with higher inflation, since it allows lower or negative real rates which makes it cheaper to finance. But the mix of unemployment will also play a role in FOMC thinking.

On Saturday I had the good fortune to play golf with Bill Dudley. He denied that he was captain of the Federal Reserve golf team, in spite of what I saw as evidence in support. We spent much time exchanging views on Fed policy and the outlook for rates. Dudley thinks the happy combination of declining inflation and a rate cycle peak of around 3%, as laid out in the most recent FOMC projection materials, will be hard to achieve. I think if Dudley was on the FOMC today they would have acted against inflation in a more timely fashion.

The Fed has committed the biggest inflation mistake in its history. The FOMC won’t concede such, but their hawkish shift shows it was obvious before The Economist made it official. They’re still a long way from creating tight financial conditions. Leave the bond market to those who tolerate returnless risk.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.