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

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

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

.avia-image-container.av-1rn6w12-be5c077d650763a8ffe23869a1cd1b1a img.avia_image{ box-shadow:none; } .avia-image-container.av-1rn6w12-be5c077d650763a8ffe23869a1cd1b1a .av-image-caption-overlay-center{ color:#ffffff; }

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

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

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

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

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

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

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

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

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

.avia-image-container.av-13hgvja-d9b516980398803a98f98e03b1d47723 img.avia_image{ box-shadow:none; } .avia-image-container.av-13hgvja-d9b516980398803a98f98e03b1d47723 .av-image-caption-overlay-center{ color:#ffffff; }

.avia-image-container.av-r65ihy-5a573e5e7c49552874189df4c0c11832 img.avia_image{ box-shadow:none; } .avia-image-container.av-r65ihy-5a573e5e7c49552874189df4c0c11832 .av-image-caption-overlay-center{ color:#ffffff; }

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

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

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

Energy Mutual Fund

Energy ETF

Inflation Fund

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

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

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

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

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

.avia-image-container.av-z2uzyl-3b7e0f4726de872227330b2878a5cbb4 img.avia_image{ box-shadow:none; } .avia-image-container.av-z2uzyl-3b7e0f4726de872227330b2878a5cbb4 .av-image-caption-overlay-center{ color:#ffffff; }

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

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

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

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

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

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

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

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

.avia-image-container.av-38izt9-3a51a3c828513d065d97094b22779a2d img.avia_image{ box-shadow:none; } .avia-image-container.av-38izt9-3a51a3c828513d065d97094b22779a2d .av-image-caption-overlay-center{ color:#ffffff; }

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

Energy Mutual Fund

Energy ETF

Inflation Fund

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

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

.avia-image-container.av-1m6np7n-bcf23c6d472893592f0cec8b96669058 img.avia_image{ box-shadow:none; } .avia-image-container.av-1m6np7n-bcf23c6d472893592f0cec8b96669058 .av-image-caption-overlay-center{ color:#ffffff; }

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

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

.avia-image-container.av-gx6ar-4fd88cf71216cf7e16e37a5cf26d1f2b img.avia_image{ box-shadow:none; } .avia-image-container.av-gx6ar-4fd88cf71216cf7e16e37a5cf26d1f2b .av-image-caption-overlay-center{ color:#ffffff; }

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

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

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

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

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

.avia-image-container.av-rp58o3-98e11496151e271270d33f2bf1a20870 img.avia_image{ box-shadow:none; } .avia-image-container.av-rp58o3-98e11496151e271270d33f2bf1a20870 .av-image-caption-overlay-center{ color:#ffffff; }

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

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

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

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

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

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Students of stock market history will know that September is seasonally the worst month of the year. This month is typical. Some may think it’s October because of the crashes that month in 1929 and 1987. Only a few years into my Wall Street career, I returned home on October 19^th, 1987, and solemnly warned my wife that a depression was coming. She scoffed that it was a problem for Wall Street not Main Street, and thus emboldened has ever since retained modest skepticism about my market prognostications.

The fourth quarter historically offers the best returns. It’s easy to go down a rabbit warren of meaningless relationships with seasonal patterns. A wet weekend ten days ago didn’t mean golf would be rained out this past weekend, even though it was. One quarter of the four is going to be the best. Since 1980 the 1.6% average fourth quarter return follows the seasonally weakest third quarter of 0.3%. The relationship has persisted for over a century.

.avia-image-container.av-87519s-69d8ce8d4e4bf475f211e3335585de9c img.avia_image{ box-shadow:none; } .avia-image-container.av-87519s-69d8ce8d4e4bf475f211e3335585de9c .av-image-caption-overlay-center{ color:#ffffff; }

MLPs used to have a distinct quarterly seasonal pattern around distribution dates. MLP buyers are often yield-driven and like those quarterly payments. K1s also induce sales before year-end and purchases right after, in both cases to avoid a K-1 for just a few weeks of January (see Why MLPs Make a Great Christmas Present). Fewer MLPs are not just causing rebalancing challenges for Alerian-linked products (see Alerian Still Clinging On). They’re also making the seasonals less pronounced.

More interesting is whether the approaching fourth quarter will hew to the historical pattern.

.avia-image-container.av-1svwjio-5613977b628eed0b173b5db405675cde img.avia_image{ box-shadow:none; } .avia-image-container.av-1svwjio-5613977b628eed0b173b5db405675cde .av-image-caption-overlay-center{ color:#ffffff; }

Recently I switched to Bloomberg TV from CNBC as my background noise of market commentary. I chose substance over entertainment. All day long executives and market participants are discussing interest rates and crude oil. Both are responsible for September’s weak equity market performance, and the energy sector’s resurgence. The macro outlook always offers reasons to worry.

.avia-image-container.av-10iha34-34ad84576ebd7b5670140c89599b05d2 img.avia_image{ box-shadow:none; } .avia-image-container.av-10iha34-34ad84576ebd7b5670140c89599b05d2 .av-image-caption-overlay-center{ color:#ffffff; }

We’ve stopped worrying about the Fed causing a recession (see Jay Powell’s Victory Lap). With the economy coping well with 4.5% ten year treasury yields, there’s concern that rates will remain higher for longer. The Equity Risk Premium (ERP) shows stocks are expensive compared to the past couple of decades, and around neutral going back to 1960.

.avia-image-container.av-lcei1c-cd457e72dd3b21688f609d6d90e41592 img.avia_image{ box-shadow:none; } .avia-image-container.av-lcei1c-cd457e72dd3b21688f609d6d90e41592 .av-image-caption-overlay-center{ color:#ffffff; }

Bond yields are moving higher with inflation expectations as defined by TIPs remaining well behaved at under 2.5%. Consequently, real yields have breached 2%. Early last year they were negative. Bonds are a better investment than they’ve been for years, though to this writer still inadequate to compensate for our fiscal outlook.

Crude oil is moving steadily higher, causing some economists to worry that this will pressure consumers’ disposable income. The dismal science usually sees problems. We energy investors are not alone in liking the rally in crude (see The Super Cycle Or Peak Oil?). At the margin it should boost demand for electric vehicles. Higher oil and gas prices support a faster energy transition. Sincere climate extremists, if there are any, should rejoice.

Occidental (OXY) CEO Vicky Holub told Bloomberg TV she saw no evidence of demand destruction in response to rising oil. JPMorgan sees OXY keeping capex flat next year versus this, and overall is forecasting a 7% annual decline in E&P drilling budgets. They are better positioned than the International Energy Agency to have an informed opinion on the topic.

If the coming quarter follows the seasonal pattern of providing the year’s best return, perhaps it’ll be because the challenges caused by rising rates and oil prices will not be enough to derail the US economy. They are “known knowns” to partially quote former Defense Secretary Donald Rumsfeld. And if you find those headwinds leave you nervous about the broader market, you’ll find that midstream energy infrastructure has exhibited more robust performance in recent months.

JPMorgan, Wells Fargo and Morgan Stanley all considered the impact of the shrinking MLP universe on Alerian’s indices and the funds and products that are linked. The cost of running a non-RIC-compliant dedicated MLP fund in a RIC structure (corporate taxation) becomes increasingly difficult to justify with a smaller universe of stocks (Morgan Stanley). As more and more large-cap MLPs get eliminated from the indices, the Alerian becomes further imbalanced (Wells Fargo). We would not be surprised to see a methodology change emerge again, potentially lifting the maximum ceiling weight to 15% (JPMorgan).

We have written at length about the contradictions of owning a portfolio of 100% MLPs in a taxable, non-RIC compliant ‘40 Act fund, so have nothing new to add. Holders of such funds will eventually conclude they shouldn’t have been.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

In March of 2020 when crude oil was collapsing dragging energy stocks, including pipelines, along, I tried to focus on the positive, which was that it had become cheaper to drive places. Except there was nowhere to go because of the lockdown. And even if there had been, I would have had to make roughly three round trips to the moon and back to generate enough savings on gasoline to compensate for my losses on infrastructure.

What some might deem an imprudently high allocation to the sector was paired with a timid appetite for leverage (ie there was none). With no need to sell I was miserable only until prices started recovering. Having endured low oil prices, I find high prices wholly more agreeable.

.avia-image-container.av-1m0vsmd-2f9ef52339f7d01ffd90962b869601f7 img.avia_image{ box-shadow:none; } .avia-image-container.av-1m0vsmd-2f9ef52339f7d01ffd90962b869601f7 .av-image-caption-overlay-center{ color:#ffffff; }

Therefore, JPMorgan’s chart depicting a widening supply deficit over the next several years causes me little angst. Those around me might even enjoy my pleasant demeanor if the forecast is true.

Interestingly, JPMorgan’s 2028 forecast of global demand matches the International Energy Agency (IEA) in their Oil 2023 publication at 105.7 Million Barrels per Day (MMB/D), an annual growth rate of just under 1%. Both agree that gasoline demand will soften while other oil products such as jetfuel, LPG and heating oil will continue to rise.

However, they reach very different conclusions on supply. The IEA is more bullish on US output, and therefore doesn’t foresee a supply/demand imbalance. By contrast, JPMorgan expects only 1% annual US production growth. They attribute this to (1) declining productivity, (2) continued focus on accretive projects to drive shareholder returns, and (3) higher interest rates. They see US upstream capex declining 7% annually through 2030.

The result is that JPMorgan is overweight global energy, proclaiming the “Supercycle returns.” They believe, “the upside risk to oil is $150 per barrel over the near to medium term.” They see a “higher for longer” outlook as financial discipline and increased cost of capital combine with “institutional and policy led pressures driving an accelerated transition away from hydrocarbons and peak demand fears.”

The IEA report strikes a more politically correct tone, asserting that increased investment in renewables is bringing “peak oil demand into view.” Reading it is supposed to leave investors in traditional energy despondent. JPMorgan disagrees: “We don’t see peak oil demand on our investment horizon (2030)”. They have a multi-year bullish outlook.

The IEA has a more optimistic supply view combined with a more pessimistic demand outlook. Energy producers embracing both would be disinclined to invest in the very supply growth the IEA expects. They’re forecasting peak oil within a decade or so to stimulate increased capex in oil projects that typically require well over a decade to generate an acceptable return. Only one part of that scenario can plausibly occur.

Analysts at Citi and Bank of America are similarly bullish, which contrarians will view as evidence of an already crowded trade.

.avia-image-container.av-12ecp1h-a204b612088e732c1693ef81c6a99933 img.avia_image{ box-shadow:none; } .avia-image-container.av-12ecp1h-a204b612088e732c1693ef81c6a99933 .av-image-caption-overlay-center{ color:#ffffff; }

If crude oil was falling, we’d note the unimportance of commodity prices to the pipeline sector. Rising prices reflect improving sentiment towards the energy complex and perhaps a modest EBITDA uplift for midstream infrastructure. But given attractive valuations, as generalist investors have begun to revisit their exposure to energy it doesn’t take much to push the sector higher. Market outperformance of the American Energy Independence Index has coincided with the rally in crude oil. They’re likely to continue moving up together.

Oneok’s (OKE) acquisition of Magellan Midstream (MMP) was approved by owners of both companies last week. Now comes the big rebalancing. MMP unitholders will receive $25 per unit, which means about $5BN in cash will be available for reinvestment early this week. Some will be set aside for taxes, but much of what’s left will go back into midstream c-corps, which should give the sector a bid.

$5.6BN is the amount of MLPs the Alerian MLP ETF (AMLP) would have to sell if they decide to rebalance away from the declining MLP sector towards c-corps. Wells Fargo reviewed the challenges this is creating for MLP-dedicated funds that follow Alerian indices. It’s an issue we have noted in the past.

The family of Invesco Steelpath funds would have to sell around $4.5BN in MLPs if they similarly rebalanced. Neither will want to make such a choice after the other. And if Alerian changes their index construction it might force the issue.

As much as $10BN of MLP positions might be swapped into c-corps if such a rebalancing goes ahead. Wells Fargo reviewed the available options but stopped short of predicting what will happen. The issue won’t go away. Fund flows ought to favor c-corps over MLPs.

.avia-image-container.av-20421x-8d636341176c0fcc3dd03057bafa6a01 img.avia_image{ box-shadow:none; } .avia-image-container.av-20421x-8d636341176c0fcc3dd03057bafa6a01 .av-image-caption-overlay-center{ color:#ffffff; }

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

Energy Mutual Fund

Energy ETF

Inflation Fund

A couple of weeks ago in Windpower Faces a Tempest, we highlighted the challenges facing offshore wind both in the US and Europe. A good friend of mine, a lawyer who has made his career doing energy deals, took issue with the blog post. A spirited text message interaction ensued, continued in person over two rounds of golf together this weekend.

Most lawyers are proficient debaters. Our younger daughter is heading to law school, perhaps inspired by my observation that she never loses an argument, just runs out of time. My legal friend eloquently argued his case in between parring most holes, challenging me to match him on two dimensions. My putting suggests I was more focused on the shortcomings of windpower.

In the blog post, I used offshore windpower examples to illustrate the challenges facing the industry. The US is almost all onshore wind, where the economics are better. Offshore windpower is more common in other countries such as the UK. I was criticized for conflating challenged US offshore wind with far larger and generally successful onshore.

The US Energy Information Administration (EIA) publishes data on windpower generation by state. In 2022 five states in the central US (Illinois, Iowa, Kansas, Oklahoma and Texas) were responsible for half our output.

.avia-image-container.av-1bigoik-0235e4db137398c47af3f8bdc7478934 img.avia_image{ box-shadow:none; } .avia-image-container.av-1bigoik-0235e4db137398c47af3f8bdc7478934 .av-image-caption-overlay-center{ color:#ffffff; }

The Administration has a goal of adding 30GW of offshore windpower by 2030. The US Department of Energy reports that 52 Gigawatts of offshore windower is in development, half of which is off the coasts of New Jersey, New York and Massachusetts. These are the economically challenged projects highlighted in the earlier blog post, and also by RBN Energy (see When The Wind Blows – Potential Project Cancellations Highlight Difficulties For Offshore Wind). Less than 1 GW is under construction. The struggles of many offshore projects are threatening the 30GW goal.

The US has 145GW of installed onshore windpower capacity. The EIA reports that wind provides around 10% of our electricity, with natural gas at 40%. According to the Energy Institute’s Statistical Review of World Energy, renewables (mostly solar and wind) provided 8.8% of America’s primary energy last year, up from 8% in 2021. Renewables are growing, but past energy transitions took decades and so will this one. Natural gas rose from 32.2% to 33.1%. Renewables’ % growth rate is much higher, but America’s biggest source of added energy last year was natural gas.

The intermittency of solar and wind remains a significant obstacle at higher levels of grid penetration. If weather-dependent energy is 5% of your power supply a calm cloudy day doesn’t much matter, but at increased levels it becomes part of the baseload. Electricity needs to be available 100% of the time. Batteries are becoming part of the solution, as are natural gas power plants because they can adjust their power output fairly easily. But the low costs sometimes floated for renewables often ignore the needed backup.

.avia-image-container.av-lmaanw-e3a97d4ba38dbb664fed6818f1da0a23 img.avia_image{ box-shadow:none; } .avia-image-container.av-lmaanw-e3a97d4ba38dbb664fed6818f1da0a23 .av-image-caption-overlay-center{ color:#ffffff; }

Germany, which generates a fifth of its primary energy from renewables, is an example of the consequent high energy prices that accompany such policies. California is another. Within the US there’s no clear link between windpower penetration and electricity prices. Iowa gets over half its power from wind and enjoys relatively cheap electricity. It must be a reliably windy place.

By contrast, solar power does tend to correlate with higher prices. It’s not just California (18% solar) but states such as Massachusetts and Vermont where one would think their northern latitudes render them unattractive locations. Prices are even more clearly linked with a state’s politics. Red states have cheaper power than blue ones.

Why would anyone want to live in a place that relies on intermittent power.

It’s not just climate extremists pushing the narrative that renewables are the complete solution to our energy needs. Liberal states such as New York and Massachusetts pursue policies that impede additional natural gas use. The Bay state has among the dumbest energy policies around. Six years ago Enbridge gave up on their Access Northeast natural gas pipeline, which would have supplied New England with cheap Marcellus gas, because of unsupportive policies in the region. Nonetheless, last year 77% of electricity in Massachusetts came from gas, almost 2X the US average. Some of it was imported expensively from foreign countries as LNG.

If we face an existential climate threat these fanatics should also embrace nuclear power as a vital solution. Finding a place to store nuclear waste remains unresolved, and costs are currently prohibitive. Georgia Power’s Vogtle nuclear plant started operations in March, years late and at $35BN cost double the original estimate. But France gets 32% of its primary energy from nuclear. America is 7.6%. The global figure is 4%. We should emulate the French.

My learned friend and I agreed on much, including that natural gas will be a significant energy source for the foreseeable future. But he was right to note that US offshore wind is a trivial source of power today. Next time I’m putting for the win he’ll probably distract me with a positive comment about renewables. I’m betting I’ll still make it.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Crude oil has rallied recently, in a much delayed reaction to numerous analyst forecasts that have been bullish all year. A couple of months ago Goldman’s commodities head Jeff Currie, who is leaving the bank, cut his year-end forecast for Brent crude from $95 per barrel to $86 while maintaining his long term bullish outlook. He blamed ongoing releases from the US Strategic Petroleum Reserve (SPR) and “a more discerning approach to sanctioned oil,” meaning that Iran and Russia are exporting more than he expected.

Currie and other analysts have maintained a bullish long term outlook because they see a growing supply-demand imbalance. This has been delayed by the issues mentioned above, but there are signs that crude is entering a sustained uptrend.

.avia-image-container.av-4i9xyn9-1e8bbea5eea5dca1010ba62abb8f9acd img.avia_image{ box-shadow:none; } .avia-image-container.av-4i9xyn9-1e8bbea5eea5dca1010ba62abb8f9acd .av-image-caption-overlay-center{ color:#ffffff; }

Sales from the SPR have weighed on prices. Last year the Administration released crude oil prior to the midterms, leading to criticism that they were cynically risking our energy security in a short-term effort to buy votes. While this was likely the motivation, sales have continued and the SPR is at its lowest level in forty years.

The US consumes about 20 Million Barrels per Day (MMB/D) of crude oil and petroleum products, a figure that hasn’t changed much in over two decades. The sharp decline in the SPR means it covers just 17 days of consumption compared with the 30-40 days that was common for much of the SPR’s existence.

.avia-image-container.av-3snj345-e3ed2e00906f65bcb562e69b0c969d84 img.avia_image{ box-shadow:none; } .avia-image-container.av-3snj345-e3ed2e00906f65bcb562e69b0c969d84 .av-image-caption-overlay-center{ color:#ffffff; }

The 1975 Energy Policy and Conservation Act was passed in response to the 1973-74 OPEC oil embargo during the Yom Kippur War. America’s energy security is dramatically different nowadays, thanks to fracking and horizontal drilling. The White House is likely to dip into the SPR again in the run up to next year’s election. Doing so will be politically expedient, but perhaps we no longer need to keep oil in storage given our ready access to domestic supply.

.avia-image-container.av-p8m2yt-ad667856df8a81398c987d03ad7a0bac img.avia_image{ box-shadow:none; } .avia-image-container.av-p8m2yt-ad667856df8a81398c987d03ad7a0bac .av-image-caption-overlay-center{ color:#ffffff; }

OPEC+ has responded by limiting supply, since they want the highest price that can sustain current demand. OPEC expects global oil demand this year to set a new peak of 102.1 MMB/D and to rise further next year.

.avia-image-container.av-wsa6at-9f159d0d9684c87a39625e39be22485d img.avia_image{ box-shadow:none; } .avia-image-container.av-wsa6at-9f159d0d9684c87a39625e39be22485d .av-image-caption-overlay-center{ color:#ffffff; }

Meanwhile they see a growing supply shortfall, exacerbated by the Saudis and Russia extending their 1.3 MMB/D cut through year’s end. Other analysts agree.

.avia-image-container.av-2emkzc5-17f4fb4b75968c37c4d24e83b103f653 img.avia_image{ box-shadow:none; } .avia-image-container.av-2emkzc5-17f4fb4b75968c37c4d24e83b103f653 .av-image-caption-overlay-center{ color:#ffffff; }

.avia-image-container.av-2433acl-81e876ae11049f592f68d5d21e755dee img.avia_image{ box-shadow:none; } .avia-image-container.av-2433acl-81e876ae11049f592f68d5d21e755dee .av-image-caption-overlay-center{ color:#ffffff; }

The International Energy Agency (IEA) expects 2024 global oil demand growth less than half of OPEC’s. They see gasoline demand peaking over the next couple of years at 26.6 MMB/D as Electric Vehicles (EVs) continue to gain market share, especially in China. They see EV sales growing from 10.8 million last year to 25.9 million by 2028, at which point they’d represent more than a quarter of new car purchases. By then crude oil demand will be over 3 MMB/D lower than without EVs.

.avia-image-container.av-1kivs11-bf74de02ccb100146680cd85fcb1bd1e img.avia_image{ box-shadow:none; } .avia-image-container.av-1kivs11-bf74de02ccb100146680cd85fcb1bd1e .av-image-caption-overlay-center{ color:#ffffff; }

However, since China gets 60% of its total energy from coal and 71% of its electricity, the growth in EVs led by China hardly seems a cause for celebration. Given the greenhouse gas emissions and local pollution from coal, it’s quite possible the world would be better off if China stuck with internal combustion engines.

The Tesla owners I know love their cars, but they all have another conventional car for long trips. An Uber driver once told me that she was happy with the Tesla leased from the company but confessed to spending an hour recharging it in the middle of every day. EV sales have momentum, but I’m in no great rush to join. It’s bad enough worrying about recharging my iphone battery, never mind my wheels.

The IEA expects growth in jet fuel and petrochemicals (lubricants, solvents etc) will continue to push global oil demand higher at around a 1% annual rate. Nonetheless, they share the short term concern of others that low inventories, extended OPEC+ production cuts and increased demand from developing countries could push prices higher over the near term.

.avia-image-container.av-13hgvgl-e8791571cafb0b7ba6afbfd830b4c6ff img.avia_image{ box-shadow:none; } .avia-image-container.av-13hgvgl-e8791571cafb0b7ba6afbfd830b4c6ff .av-image-caption-overlay-center{ color:#ffffff; }

Discussion of the correlation between crude oil and midstream energy infrastructure is common when they’re both falling. We’ve written about this topic in the past. The relationship between pipeline stocks and commodities has been weak over the past couple of years (see Oil And Pipelines Less In Sync) However, over the last three months Brent crude has risen over $15 per barrel, coinciding with a run of market outperformance by the American Energy Independence Index (AEITR).

Pipeline companies are unlikely to revise earnings guidance, but there’s little doubt that this latest move shows sentiment towards the energy sector is improving. The fundamentals have been strong for a long time, so to us a rallying AEITR seems fully justified.

.avia-image-container.av-m0ozhh-72c15f038ee81e9dffce2ad2779d4881 img.avia_image{ box-shadow:none; } .avia-image-container.av-m0ozhh-72c15f038ee81e9dffce2ad2779d4881 .av-image-caption-overlay-center{ color:#ffffff; }

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

Energy Mutual Fund

Energy ETF

Inflation Fund

The old MLP model rarely saw stock buybacks. Traditionally the General Partner (GP) would sell assets to the MLP it controlled in a non-arms-length transaction. The MLP would issue equity and debt to pay for them. MLPs were sellers of their own units, not buyers.

Today’s midstream energy infrastructure sector has left that model behind. Most companies are corporations and most have buyback programs in place. Of the names listed, 12 of 16 retired some stock last year and 14 are expected to do so this year.

.avia-image-container.av-3ndfdna-5597f25a0233178bbfeb737595bf2644 img.avia_image{ box-shadow:none; } .avia-image-container.av-3ndfdna-5597f25a0233178bbfeb737595bf2644 .av-image-caption-overlay-center{ color:#ffffff; }

The buyback yield (ie portion of outstanding shares repurchased) can be added to the dividend yield to give the total return to shareholders exclusive of price changes. By this measure, half the sixteen companies listed offer a return of 7.9% or greater, assuming they execute their buyback programs as JPMorgan projects through the remainder of the year.

This year’s median dividend yield + buyback yield of 7.9% is up from 7.4% last year, a 7% growth rate. Returns are increasing.

.avia-image-container.av-2xkn5xy-4050c54a9e5a028c4087592ab5302d1f img.avia_image{ box-shadow:none; } .avia-image-container.av-2xkn5xy-4050c54a9e5a028c4087592ab5302d1f .av-image-caption-overlay-center{ color:#ffffff; }

MLPs are repurchasing shares alongside their c-corp peers. Without a controlling GP poised to drop down assets they have more conventional growth capex opportunities of acquisitions and re-investing back in the business.

M&A activity has picked up recently, with Oneok’s (OKE) acquisition of Magellan Midstream (MMP) and Energy Transfer’s (ET) purchase of Crestwood. Investors worried that ET’s issuance of $2.7BN in equity to fund this purchase indicated that buybacks were a lower priority. But the company assuaged these fears with a presentation that earmarks up to 20% of distributable cash flow to buybacks once they’ve reduced their Debt:EBITDA ratio close to 4.0X.

The OKE/MMP deal looks likely to receive shareholder approval now that independent proxy firms Glass Lewis and ISS both recommended a yes vote.

The dealmaking reflects increased confidence in the sector’s outlook by management.

.avia-image-container.av-9k50ba-306a248475a9366128b76d092a515735 img.avia_image{ box-shadow:none; } .avia-image-container.av-9k50ba-306a248475a9366128b76d092a515735 .av-image-caption-overlay-center{ color:#ffffff; }

Many companies have revised up their 2023 EBITDA over the past year without seeing it reflected in stock price performance.

Valuations are still below where they were in 2019 before the pandemic, even though companies have de-risked by reducing leverage. Enterprise Value/EBITDA averaged 11.5X for the sector according to JPMorgan and is below 10.0X today. Leverage is coming down and dividends are growing. Capex remains well below the levels of 2018, partly because environmental extremists have turned the courts into a weapon against all kinds of infrastructure including renewables (see Windpower Faces A Tempest). This has helped improve free cash flow among pipeline companies.

Canada has similar problems. The TransMountain expansion from Alberta to British Columbia has quadrupled in cost since Kinder Morgan deftly sold it to the Canadian government in 2018. The ultimate tab might go even higher. Engineering difficulties have led the company to request a different route, but the indigenous community is opposed. Public hearings are scheduled, and the crude pipeline’s completion could be pushed back a further nine months to the end of next year. Unlike in the US, Canada’s native tribes never signed peace treaties with the European settlers. As a result they have greater legal rights including limited sovereignty over their land. Canadian construction projects often have to work around this, as TransMountain is having to.

Unexpected delays are common in pipeline projects, which is why it’s unattractive to build them. This makes the existing stock of infrastructure more valuable.

I used to think climate extremists were trying to put us out of business, but I have since developed a more subtle appreciation of their positive impact on free cash flow since there’s less spending on new pipeline construction.

Hug a climate protester and drive him to his next protest.

.avia-image-container.av-24x7tjq-ab65de2ffb9a6bb27791cc9eb4e333bf img.avia_image{ box-shadow:none; } .avia-image-container.av-24x7tjq-ab65de2ffb9a6bb27791cc9eb4e333bf .av-image-caption-overlay-center{ color:#ffffff; }

In spite of all these positives, after two very strong years the pipeline sector as represented by the American Energy Independence Index is lagging the broader market this year. It looks cheap to us.

US natural gas prices have been weak in recent months. Domestic demand isn’t growing fast enough to match production – the market needs more liquefaction capacity.

.avia-image-container.av-1nrxljq-5faf7fa5f6743c70028591caa2f900f7 img.avia_image{ box-shadow:none; } .avia-image-container.av-1nrxljq-5faf7fa5f6743c70028591caa2f900f7 .av-image-caption-overlay-center{ color:#ffffff; }

Fortunately, that’s coming. The US Energy Information Administration (EIA) expects gross LNG exports to reach 14 Billion Cubic Feet per Day (BCF/D) by the end of next year. The net may be smaller if Massachusetts imports LNG as they have in the past (see Why Staying Warm In Boston Will Cost You).

.avia-image-container.av-14vu586-ec55199b13953de79efc0ae72ae6c16f img.avia_image{ box-shadow:none; } .avia-image-container.av-14vu586-ec55199b13953de79efc0ae72ae6c16f .av-image-caption-overlay-center{ color:#ffffff; }

Based on projects under construction, we should be exporting 24 BCF/D by 2027, a doubling over five years. This will add upward pressure to cheap US prices and will enable other countries to reduce their use of coal for power generation.

The valuations, strong fundamentals and growth prospects make this one of the most overlooked sectors in the market.

.avia-image-container.av-kkczee-a4d4970d3f3c7cb34c7fe88f9bbe2019 img.avia_image{ box-shadow:none; } .avia-image-container.av-kkczee-a4d4970d3f3c7cb34c7fe88f9bbe2019 .av-image-caption-overlay-center{ color:#ffffff; }

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

Energy Mutual Fund

Energy ETF

Inflation Fund

At the end of August Orsted, a Danish developer of wind turbines, announced they’d be delaying their first planned installation off the New Jersey coast until 2026. They blamed supply chain issues, interest rates and insufficient US Federal tax credits. The Federal government had only recently approved the project.

New Jersey Democrat governor Phil Murphy and the Democrat-controlled legislature are big proponents of the garden state switching to windpower. New Jersey has regrettably moved to the left in recent years, partly because Republican voters are leaving for southern states such as Florida.

.avia-image-container.av-3mn8b0o-5d4a6dc86b67c5f37c728b33b8d538da img.avia_image{ box-shadow:none; } .avia-image-container.av-3mn8b0o-5d4a6dc86b67c5f37c728b33b8d538da .av-image-caption-overlay-center{ color:#ffffff; }

But even though New Jersey is a solidly blue state, there is plenty of opposition to windpower along the Jersey shore, which tends to be more conservative. Cape May county, opposite which the wind turbines are planned, is both especially conservative and opposed. Turbines already in place are blamed for a jump in whale deaths although this is disputed. It’s also feared that they will spoil the view. Protect Our Coast NJ is adopting some tactics from the environmental extremists’ playbook in using court challenges to impose costly delays. Treasurer Frank Coyne said, “The objective is to hold them up and make the cost so overwhelming that they’ll go home.”

The cost of installing windpower is going up. Orsted said it may take a $2.3BN writedown on its US projects. New Jersey Democrats even passed legislation redirecting Federal tax credits from residents to Orsted in order to make the economics more appealing. The delay until 2026 means the project won’t be completed before Phil Murphy leaves office, casting further doubt over its ultimate viability. Orsted has said it considered abandoning the project but for now intends to proceed, which is likely to encourage opponents to keep up the pressure. So far they’ve invested $4BN in US offshore wind projects including Montauk point at the tip of Long Island, and Rhode Island. They plan to make a final investment decision on all three by early next year.

Orsted is not alone. Spain’s Iberdrola canceled a planned wind farm off the coast of Massachusetts. Sweden’s Vattenfall backed out of a project off the coast of Britain, citing cost inflation. Siemens is expected to lose up to $5BN in its wind turbine manufacturing unit.

It’s tough to make money in renewables.

.avia-image-container.av-370s3u0-2d2e7863cf5dfeb95df97438644f86ce img.avia_image{ box-shadow:none; } .avia-image-container.av-370s3u0-2d2e7863cf5dfeb95df97438644f86ce .av-image-caption-overlay-center{ color:#ffffff; }

Then there’s NextEra Energy (NEE) and its MLP NextEra Energy Partners (NEP). NEE is “an industry-leading clean energy company” and is building its renewables capability as fast as it can. Four years ago we wondered if rapid depreciation in its asset base would ultimately hurt earnings (see Is NextEra Running in Place?). At the time the company was depreciating 5.5% of its Property, Plant and Equipment (PP&E), higher than other utility companies and suggesting a useful life of under twenty years.

Rapidly improving costs for renewables power generation cause older equipment to depreciate more quickly. And solar always faces the challenge that if a region is sunny enough a utility might find its customers investing in their own solar panels and batteries, disconnecting from the distribution network which means the fixed cost of transmission lines is spread across fewer users. It still doesn’t look like an appealing business to us.

.avia-image-container.av-2pstfm0-6fe5bae34726ae7bcae49554aff41a1e img.avia_image{ box-shadow:none; } .avia-image-container.av-2pstfm0-6fe5bae34726ae7bcae49554aff41a1e .av-image-caption-overlay-center{ color:#ffffff; }

NEE pulled ahead of the American Energy Independence Index (AEITR) for the next three years following our 2019 blog post, and its depreciation as a % of PP&E fell back to its peer group. In recent weeks it’s lagged and is now behind the AEITR over that time period. Over the past year NEE and NEP have substantially underperformed the AEITR.

.avia-image-container.av-231ejqg-6795bdc50b33cba11dbb14cc6130cb7d img.avia_image{ box-shadow:none; } .avia-image-container.av-231ejqg-6795bdc50b33cba11dbb14cc6130cb7d .av-image-caption-overlay-center{ color:#ffffff; }

An investor asked me last week what I thought of NEP. It is an old-fashioned MLP, with a controlling General Partner (GP) that can drop down assets. Midstream energy infrastructure, still known colloquially as the MLP sector, used to have many similar structures. The GP, in this case NEE, has a similar position to a hedge fund manager with respect to her hedge fund, in this case NEP.

.avia-image-container.av-1s1u5ew-c4251bb637510301f777fbe3668eac29 img.avia_image{ box-shadow:none; } .avia-image-container.av-1s1u5ew-c4251bb637510301f777fbe3668eac29 .av-image-caption-overlay-center{ color:#ffffff; }

When MLPs were controlled by a GP, we always favored the GP, just as you’d rather be the hedge fund manager rather than a hedge fund client. In 2012 I published The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True which revealed how investors had in aggregate done poorly in spite of hedge funds being wildly profitable, because fees had siphoned those returns over to the manager.

We recognized the analogy with MLPs and their GPs. NEE is NEP’s GP. They retain the old model but are in new energy. So we would avoid NEP and favor NEE because we always prefer the GP.

.avia-image-container.av-19c1w3s-623eecb1cfafc383bf183a76bd0db4a0 img.avia_image{ box-shadow:none; } .avia-image-container.av-19c1w3s-623eecb1cfafc383bf183a76bd0db4a0 .av-image-caption-overlay-center{ color:#ffffff; }

Nonetheless, it’s easy to see why both stocks look attractive especially if you want exposure to solar and wind. Within three years NEE is planning to have more renewable generation capacity than total installed capacity for any other US company. NEP is planning to sell its natural gas pipeline business and be 100% renewables.

.avia-image-container.av-jcawmg-9c976ed1b561c1b676410f04b06157d3 img.avia_image{ box-shadow:none; } .avia-image-container.av-jcawmg-9c976ed1b561c1b676410f04b06157d3 .av-image-caption-overlay-center{ color:#ffffff; }

NEP yields 7.6% and is guiding for 12% annual distribution growth. Its one year total return is –40%, probably dragged down by the challenges faced by Orsted and others.

NextEra’s wildly bullish outlook on renewables runs counter to the experience of the windpower manufacturers. They are a pureplay bet on renewables profitability, contrasting with writedowns being taken elsewhere in the industry.

It’ll be fascinating to see how this plays out.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

The members of the Federal Open Market Committee (FOMC) could be forgiven for feelings of quiet satisfaction. They’ve raised short term rates higher than most observers expected, and odds of the consequent recession have been receding. The increase in the unemployment rate to 3.8% on Friday leaves it still well below full employment. Yet inflation expectations remain well contained. The University of Michigan survey reports a five year outlook of 3%. Republicans (3.3%) are more pessimistic than Democrats (2.7%), but members of the White House’s incumbent party are generally more willing to think things will work out.

Inflation expectations from the bond market tell a similar story, with ten year inflation derived from TIPs at 2.3%. All this is consistent with a Personal Consumption Expenditures (PCE) deflator of 2%, since its construction means it tends to run a little lower than the CPI that most people rely on. Fed credibility remains intact.

.avia-image-container.av-3ieec0o-8bc0d8fe9373783eee755ac96920786a img.avia_image{ box-shadow:none; } .avia-image-container.av-3ieec0o-8bc0d8fe9373783eee755ac96920786a .av-image-caption-overlay-center{ color:#ffffff; }

But there’s always something to worry about. Because the ten year treasury yield has drifted up to 4.25% while the inflation outlook hasn’t changed, it means real yields have risen to almost 2%. As recently as eighteen months ago real yields were negative. The distorting effect of central banks and other return-insensitive investors was sufficient to guarantee a loss of purchasing power on buyers. The current 2% real yield is close to the long term real return on treasuries.

Near term SOFR futures have barely moved over the past few weeks. Contracts five years out and longer have borne most of the upward adjustment caused by the increase in treasury yields.

.avia-image-container.av-2twesgo-2942a2aa2b8a13a646064fb27fd90847 img.avia_image{ box-shadow:none; } .avia-image-container.av-2twesgo-2942a2aa2b8a13a646064fb27fd90847 .av-image-caption-overlay-center{ color:#ffffff; }

JPMorgan revised up their 3Q23 GDP forecast to 3.5%. A few months ago they were among those forecasting a mild recession by year’s end, something they no longer expect. Factset bottom-up earnings forecasts have started to edge higher. It’s just as well, because the Equity Risk Premium (ERP), defined here as the difference between the yields on S&P500 earnings and ten year treasuries, makes stocks look as expensive as at any time in the past two decades.

.avia-image-container.av-2nabjnc-34f72174003a2dae36e6e62ba279f1ed img.avia_image{ box-shadow:none; } .avia-image-container.av-2nabjnc-34f72174003a2dae36e6e62ba279f1ed .av-image-caption-overlay-center{ color:#ffffff; }

The corollary to an expensive equity market is that bonds are cheap. It’s not something you see often on this blog, but treasuries look more attractive relative to stocks than in a long time. We wouldn’t suggest switching, because the poor US fiscal outlook makes inflation a long-term risk and fixed income investments won’t offer much protection.

.avia-image-container.av-23t126w-cce63fdc2ba53fdc38bc0806f270c253 img.avia_image{ box-shadow:none; } .avia-image-container.av-23t126w-cce63fdc2ba53fdc38bc0806f270c253 .av-image-caption-overlay-center{ color:#ffffff; }

Interest expense on the US federal debt is forecast to more than double as a percentage of GDP over the next 25 years, according to the Congressional Budget Office. Publicly held debt will rise from 100% of GDP to 169% over the same period. One of the mysteries of finance is how long term US interest rates have maintained levels seemingly oblivious to our helpless profligacy. Thirty year bonds at 4.4% can only be justified by substantial demand from buyers willing to ignore that. As well as central banks, there are sovereign wealth funds with hundreds of $BNs to invest satisfied simply with the assurance of getting their money back. Add pension funds with inflexible mandates that continued to require a fixed income holding even when yields were below 1%.

.avia-image-container.av-1g03v7c-83a539b60b3e2af63f81987e3ec565a4 img.avia_image{ box-shadow:none; } .avia-image-container.av-1g03v7c-83a539b60b3e2af63f81987e3ec565a4 .av-image-caption-overlay-center{ color:#ffffff; }

Even US banks adopted the same behavior during QE, which is why Silicon Valley Bank failed and why the industry had $515BN in unrealized losses on securities in the first quarter, albeit with an improving trend since 3Q22.

.avia-image-container.av-19ojzso-c4e0c956e59ed03f70ecfa25fdf3339e img.avia_image{ box-shadow:none; } .avia-image-container.av-19ojzso-c4e0c956e59ed03f70ecfa25fdf3339e .av-image-caption-overlay-center{ color:#ffffff; }

However, there are signs that the appetite for bonds among those that care least about the return may be waning, which is allowing real yields to rise. Kevin Coldiron is a long-time friend and retired hedge fund manager who is now a finance lecturer at UC Berkeley and co-authored The Rise of Carry. Kevin writes thoughtfully on financial markets, and a recent blog post Inflation in the Twenty-First Century Part III: A Circular Flow No Longer addresses this issue.

.avia-image-container.av-rnyddk-88694227843cfb4596a0cd2c50d4054b img.avia_image{ box-shadow:none; } .avia-image-container.av-rnyddk-88694227843cfb4596a0cd2c50d4054b .av-image-caption-overlay-center{ color:#ffffff; }

For decades the US has run a trade deficit. In aggregate, this leaves the world’s exporters with more US$ than they need, and some of them get reinvested back into US treasuries. It’s often pointed out that a trade deficit requires financing by foreigners, through asset sales or debt issuance, because our exports don’t generate enough foreign currency to pay for our imports.

Kevin neatly displays this in the first of his two charts. But he goes on to suggest that this happy state of affairs may be ending. China is reducing its holdings of US treasuries. Perhaps the sanctions imposed on Russia following its invasion of Ukraine was a factor. A $1.1TN investment in US government bonds doesn’t look like a smart move for a country pledged at some point to reunify with Taiwan.

The Federal Reserve is also shrinking its balance sheet, albeit ponderously.

There’s little reason to expect real yields to stop rising. 2% is simply the long run average. It’s only high compared with the past few years. The factors causing China and the Fed to cut back will remain indefinitely. Maybe the bond market, which is far bigger now than in 1994 when Jim Carville famously said it could “intimidate everybody,” is about to command more of our attention.

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

Energy Mutual Fund

Energy ETF

Inflation Fund