SL Advisors Talks Markets

Another Climate Conference

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COP28, the annual UN climate conference, starts tomorrow in Dubai in the United Arab Emirates (UAE). It’s easy to criticize the world’s efforts at reducing global Greenhouse Gases (GHGs). They over-emphasize intermittent solar and wind instead of going all in on nuclear and should replace coal with natural gas.

China gets a free pass to increase emissions through at least 2030 so their living standards can modestly catch up with the west. The US didn’t impose the decades of growth-stultifying communist central planning in 1949 that caused their living standards to fall behind. But we’re supposed to cut GHGs while theirs grow. President Biden and Xi Jingping, leaders of the world’s top two emitters, the US (6.4 billion Metric Tonnes (MTs) of CO2 equivalent and falling since 2007) and China (14.4 and rising) won’t be attending. The UAE, OPEC’s third biggest producer of liquid fuels, is planning to use the presence of so many energy executives in Dubai to discuss oil deals.

The US just auctioned 35,000 acres of Wyoming land to oil and gas drillers, demonstrating that the White House is acting with more pragmatism and less emotion than left-wing Democrats might like. As St. Augustine might have said, “Give me 100% clean energy (chastity), just not yet.”

3,700 US auto dealers are calling on the Administration to slow regulations requiring two thirds of new cars to be battery electric by 2032. Electric Vehicle inventories in the US are up fivefold over the past year, according to digital listing platform CarGurus.

Climate extremists despair at the apparent lack of progress. But there is plenty of evidence that the world’s energy producers are adapting to the energy transition.

Global investment in fossil fuels has yet to recover to pre-pandemic levels in real terms, while renewables investment has increased by around half in five years. Given the long lead-time in developing new oil and gas reserves, caution around capital commitments that require a decade or more to deliver a return is prudent. By most measures the world is going to be short of crude oil since demand continues to grow. The Energy Information Administration (EIA) sees global liquids consumption rising by 1.4 Million Barrels per Day (MMB/D) next year to 102.44 MMB/D, 0.4 MMB/D faster than production. China’s oil consumption grew at 3.5% annually over the past decade.

Nonetheless the price of crude has confounded many bullish oil forecasters this year.

Carbon capture received a big boost from last year’s Inflation Reduction Act (“Green Spending Act”). With tax credits for Direct Air Capture (DAC) of CO2 rising to $180 per MT, private sector investment is picking up. More than half the new capital dedicated to the sector over the next three years is expected to be in the US. The power sector, where concentrated emissions of CO2 can be sourced, will receive around half of planned investment over that time. Removing CO2, long criticized as impractical and ruinously expensive, is becoming an important tool (see Carbon Capture Gaining Traction).

American Airlines is buying carbon credits from a company that turns sawdust and tree bark into compressed bricks that are then coated and buried. This prevents the biomass from otherwise decomposing and releasing CO2 into the air. American Airlines is paying $100 per MT for the credits. Burying sawdust seems an unlikely way to reduce CO2 levels, but Graphyte’s backers include Bill Gates’s Breakthrough Energy Ventures. The company expects to start producing the bricks next month and believes their technology is cheaper than other types of carbon capture.

It’s likely that innovation in this sector, spurred by the Green Spending Act, will continue to lower costs while adding new methods.

Federal support is also stimulating new investment in pipelines to move hydrogen and CO2. Hydrogen offers promise when blended with natural gas at low percentages but generates Nitrous Oxide (NOx) at higher concentrations, as noted in this comment on a previous blog post.

The US is leading the world with new investment and innovation in reducing emissions from today’s energy and removing CO2 from the atmosphere. We’re also exporting increasing amounts of natural gas to our trading partners and allies, enabling them to use less coal for power generation. The US has a great story to tell on climate change and the energy transition, one that is underpinned by today’s midstream infrastructure companies. Climate extremists are wrong to focus their criticism on rich countries. The path of emissions in China and whether they eventually peak and then fall, will determine global levels.

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

SL Advisors Talks Markets

AMLP Is Running Out Of Names

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Next month VettaFi, which owns the Alerian indices, will announce a rebalancing of the Alerian MLP Infrastructure Index (AMZI). This will impact the Alerian MLP ETF (AMLP) which tracks AMZI. For an index fund it does a poor job of keeping up with its index – ALPS Advisors, who runs it, reports alpha of –3.03% over the past three years. That’s mostly due to the two tax restatements they made (see AMLP Has Yet More Tax Problems). Over the past year AMLP’s NAV has been adjusted down by 6%. ALPS wisely warns that, “…the daily estimate of the Fund’s deferred tax liability used to calculate the Fund’s NAV could vary significantly from the Fund’s actual tax liability.” It’s currently $329MM, around 4.3% of NAV.

AMLP’s fiscal year-end is November 30^th, so investors will be hoping for no further tax revisions like the one that was released that time last year. December 15^th is the next hurdle, because that’s when VettaFi will rebalance AMZI. It could use it. Currently, the top five names are 72% of the portfolio. Energy Transfer (ET) is over 18%. Just ten names constitute 97% of the portfolio.

AMLP is for those who like their market exposure concentrated.

Morgan Stanley recently pointed out that ET’s weight is more than 6% over the normal 12% cap. It’s not an easy problem to solve. The number of MLPs is declining – ET’s recent acquisition of Crestwood removed another one. Being an MLP-dedicated fund means to love an ever-decreasing number of names.

ET has performed well this year, with a YTD total return of 25%. ALPS didn’t decide to overweight the name, it’s a consequence of their index construction. Morgan Stanley points out that if VettaFi decides to bring ET back to 12% in their December rebalancing, that could put downward pressure on the stock.

AMLP’s distributions are also now classified as 100% income. This is a change from prior years when they were almost always a return of capital, passing through the tax deferred benefit of MLPs to AMLP holders. Evidently the tax review that led to the cumulative 6% NAV adjustment also reclassified the tax nature of their distributions. It’s unlikely many AMLP investors are aware of this, but those holding it in taxable accounts will receive another unpleasant surprise when they file their 2023 tax returns.

There is so much wrong with this fund.

It is a great example of investor inertia. At $7.5BN in AUM, financial advisors who still use AMLP draw false comfort from knowing that legions of their peers are passively accepting a pool of fewer names and uncertain tax treatment. Investment performance and portfolio construction would render this fund unable to pass the most cursory due diligence of any investment firm’s review process. Its longevity and size substitute for careful analysis.

If your financial advisor still has you in AMLP, your portfolio isn’t receiving the attention it deserves. Ask why not.

Fundamentals for midstream energy infrastructure continue to be supportive. 3Q23 earnings were generally good. The US Energy Information Administration recently noted that North American LNG export capacity is on track to at least double over the next four years, from 11.4 Billion Cubic Feet per Day (BCF/D) currently to 24.3 BCF/D. As well as five additions in the US, Mexico is adding three and Canada two.

US natural gas is among the world’s cheapest. The constraint on selling more is the capacity of the liquefaction plants currently in operation. Ramping up is a slow process, but as the chart illustrates export growth is coming. US natural gas will contribute to reduced global emissions by allowing more LNG buyers to rely less on coal.

Earlier in November Williams Companies (WMB) confirmed they’d be moving forward with their Southeast Supply Enhancement project which will increase natural gas takeaway capacity out of the Marcellus shale via their Transco pipeline network. This will increase the volume of natural gas able to go south, potentially supplying our growing LNG export capacity along the gulf coast.

RBN Energy, a research firm that provides many useful insights, noted the trend towards more investor-friendly allocation of cash flow. Last year the 13 biggest midstream companies (seven c-corps and six MLPs) returned 43% of cashflow to investors via dividends and buybacks. Add in retained cash of 6%, and this equaled the 50% share spent on capex and acquisitions.

In 2019 dividends were 48% of cashflow (there were no buybacks). Capex plus acquisitions was 83%. The difference was financed with increased debt (34% of cashflow).

Energy is a cyclical business, but the increasing dedication of cashflow to investor returns is becoming a welcome habit.

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

SL Advisors Talks Markets

Book Review – We Need To Talk About Inflation

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Steven D King is not as famous as his namesake, but for an economist can still write a spine-tingling book. Prompted by the inflation that followed the pandemic, King walks us through past episodes of inflation and their causes, and offers some clues as to whether it’s persistent or transitory.  

Moderate inflation of 2% or lower had become so entrenched that by 2020 the Federal Reserve adopted an asymmetric policy of tolerating inflation above target in order to allow the long run average to reach 2%. Policymakers worried about a Japan-style deflation as much as they fretted over inflation, and when Covid uber-stimulus caused it, the Fed maintained that it would not persist. Hence “transitory” became a flip criticism of Fed chair Jay Powell. 

Until the last hundred years or so inflation and deflation were equally likely. Although citizens in the Roman Empire suffered disastrous inflation during the third century CE, over the next fifteen hundred years or so centuries passed with little inflation and sometimes deflation. During the 15th century the British pound is estimated to have gained 11% in purchasing power. The 20th century up until today is more notable for the absence of any serious deflation. Avoiding deflation at all costs “is likely to end up delivering an inflationary bias.”  

The US 1930s depression was the most economically destructive period in the country’s history. By contrast, Germany’s experience with hyperinflation under the Weimar Republic led to the catastrophe of Hitler. Economic policy in both countries is biased to avoid a repeat – hence the Fed targets maximum employment consistent with stable prices while for decades the Bundesbank’s mandate was simply price stability.  

Quiescent inflation from the late 1980s perhaps led to central bank complacency that their credibility largely assured price stability. But some economists think globalization allowed a one-time enormous increase in the supply of cheap labor and improved supply chains. Central bankers were less important than they thought.  

The aftermath of the US Civil War saw the Federal government fear a repeat of the inflation that followed both the US and French revolutions. But northern financiers had provided extensive credit to southern farmers. The debtor benefits from inflation through a devalued obligation as much as the creditor loses out. Therefore, the deflation that followed the end of hostilities had the effect of making the South poorer while the North got richer, “…a mechanism to ensure the economic costs of the war were imposed on the former Confederate states.” 

King draws an interesting analogy with the periodic debt crises in the Eurozone, during which heavily indebted southern countries like Greece and Italy would benefit from inflation while trapped in the same currency as northern creditors such as Germany. A fracturing of the Euro was only avoided when ECB central bank head Mario Draghi pledged to do “whatever it takes” to preserve the Euro, which eventually included buying Italian and Greek sovereign debt.  

Modern Monetary Theory (MMT) receives a brief and disparaging mention, one with which we heartily agree (see The Death Of Modern Monetary Theory). MMT holds that because a government can never default in its own currency, expansionary fiscal policy should be run to maximize employment. This relies on governments constraining themselves only when forecast inflation shows the limits of productive capacity have been breached. The flaw is in expecting any government to honestly forecast inflation. Even the Fed is bad at it.  

Perhaps the biggest change in central banking in our lifetimes has been the granting of independence from political interference, at least over the short to medium term. During the late 1970s and early 1980s high inflation was a political issue and elected leaders accepted that it was their responsibility to tame it. Paul Volcker could never have driven interest rates to 21%, helping cause two recessions, without support from President Reagan and Congress. 

Central bank independence frees monetary policy from political interference, but it also frees governments from responsibility. The massive fiscal stimulus following the pandemic soon turned out to be excessive. The Fed and other central banks were rightly criticized for reacting late, but few called for the fiscal drag of spending cuts or tax hikes to offset the earlier mistake. Quantitative Easing has blurred that independence. Even wildly imprudent fiscal policy can always rely on the QE bailout. Now that excessive government debt is increasingly financed by central banks, the conduct of monetary policy is more complicated. The unfortunate milestone of $1TN in annual interest expense on Federal debt was brought two years closer, from 2030 to 2028, because the Fed raised rates.  

King offers a four-point test to see whether an uptick in inflation will be persistent or not. The Fed’s asymmetric tolerance for higher inflation, attributing it to external shocks such as covid and Russia’s invasion, and trade tensions that are constraining supply chains are three indicators of persistence. The absence of monetary excess (M2 has been shrinking for over a year) is the only one to provide comfort. King concludes that recent inflation “has been the most worrying since the 1970s.” 

His lessons from past bouts of inflation and warnings about the future make this a book worth reading for every investor.  

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

SL Advisors Talks Markets

Priced For A Pragmatic Energy Transition

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The other day a NYTimes columnist contrasted the relative outperformance of oil stocks with plunging solar and wind. He concluded that the stock market is oblivious to the threat of climate change whereas the UN and other scientists believe we must reduce Greenhouse Gas (GHG) emissions to zero by 2050. The writer, Jeff Sommer, briefly contemplated who was right – the market’s apparently sunny outlook or the scientists’ dour one. He quickly concluded that the market was wrong. Well, he is a journalist. At the NYTimes.

Sommer thinks energy investors are focused on the short term and ignoring climate change. I’m an energy investor, and I think about the energy transition all the time. If you invest in this sector you have to have a perspective on how the world’s use of energy will evolve. The International Energy Agency believes the world will eliminate GHGs by 2050, but all the data points to global energy consumption increasing and emissions maybe falling by then but certainly not reaching zero. It’s the difference between what some people think should happen and what others think will likely happen.

Energy stocks began pricing for the risk of climate change and the energy transition many years ago. The fear that crude oil reserves and natural gas pipelines would become stranded assets, abandoned well short of their useful lives, has been steadily gaining importance for at least the past decade.

The S&P Energy index, which is dominated by Exxon Mobil and Chevron who together represent 45%,  has lagged the S&P500 for seven of the past ten years and three of the past five. Along with the American Energy Independence Index (AEITR), both have underperformed the market over ten years but are approximately even over the past five. This reflected investors’ discounting the impact of the energy transition.

In 2020 investor excitement about the prospects for renewable energy peaked. The S&P Clean Energy index (“S&P Renewables”) had a huge year but has since lost half its value. That’s because many of these companies aren’t doing that well. Orsted, one of its top ten holdings, is likely to book a $5BN+ loss on its US offshore wind business. First Solar swung to a $281MM operating loss last year on revenues of $2.6BN. Over the past five years, an investment in pipelines has outperformed renewables.

But it’s not true to suggest energy investors aren’t considering climate change. It’s foremost in the thinking of most who have exposure there, and one of the top reasons for those who avoid the sector.

This is most visible in valuations. Midstream energy infrastructure corporations yield over 6% with a Distributable Cash Flow (DCF) yield of 11%, forecast to rise to 12% next year (JPMorgan). Large MLPs yield 8% with DCF yields of 14%. These are attractive valuations by most historical standards, and they’re only available because many investors still assume fossil fuels are going away within the next decade or so.

Political soundbites matter. Just over four years ago, candidate Biden said, “I guarantee you. I guarantee you. We’re going to end fossil fuel.” He wasn’t specific about when, and in a more sober moment during February’s state of the union he conceded, “We’re still going to need oil and gas for a while.”

The market is priced for his first statement and only warily acknowledges the second.

S&P Renewables soared on the election rhetoric and has plummeted on the financial results, reflecting Ben Graham’s quote that in the short run, the market is a voting machine but in the long run it is a weighing machine.

Renewables stocks have continued falling this year, even though the 2022 mis-named Inflation Reduction Act provided huge subsidies. First Solar (FSLR), the biggest component of S&P Renewables, is down by a third since March. It trades at around 18X 2023E earnings, modestly less than the S&P500 at 19.8X, so even now hardly looks out of favor. JPMorgan rates it “Overweight” calling it a “safe haven”. They have a $220 one-year price target, which is up 50% from here, and forecast 2024 EPS at $14, up from $8 this year.

Wells Fargo rates FSLR overweight with a $215 price target. They expect EPS to double next year.

This does not look like a stock short of love from sell-side analysts.

Often long term energy forecasts confuse aspirational with likely. This natural gas chart shows both. The IEA Net Zero is not in our future. Their Stated Policies one is plausible. Making such projections objective draws the ire of climate extremists. You have to screen out the hyperbole.

Jeff Sommer of the NYTimes is confusing recent market performance with valuations. Energy stocks, especially midstream, are cheap. They’ve been cheaper to be sure, especially during the first few months of the pandemic in 2020. But they are still priced defensively in our view.

The FSLR example shows a bullish outlook for solar panels. It’s just no longer priced as if Biden’s election rhetoric was anything more than a soundbite to pick up some gullible far-left votes.

The energy transition is clearly priced into energy stocks. What’s not priced in is the certainty of the world eliminating GHGs by 2050 (“Zero by 50”). That’s an extreme forecast, and while theoretically possible it’s becoming steadily less plausible every day. By their actions, people around the world are showing concern about emissions while stopping short of economic suicide by following the most extreme policy prescriptions.

Zero by 50 is intended to limit global warming related to human sources of GHGs to 1.5 degrees C above 1850. Temperatures today are already 1.1 degrees warmer than that benchmark. We’re living with it, not yet extinct.

Cost-effective emissions reduction looks like smart risk management of our only planet. Reducing living standards around the world with impetuous choices does not.

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

SL Advisors Talks Markets

Book Review – Elon Musk by Walter Isaacson

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

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

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

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

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

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

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

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

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

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

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

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