SL Advisors Talks Markets

Will Fall Seasonals Cause The Market To Rise?

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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.

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.

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.

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.

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:

SL Advisors Talks Markets

Offshore Wind vs Onshore

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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.

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.

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:

SL Advisors Talks Markets

Pipelines Returning More Cash

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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.

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.

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.

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.

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.

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).

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.

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

SL Advisors Talks Markets

Why Are Real Yields Rising?

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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.

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.

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.

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.

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%.

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.

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.

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:

SL Advisors Talks Markets

Growth Is Gassy Not Oily

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We’ve been critical of Magellan Midstream’s (MMP) proposed sale to Oneok (OKE) for months (see Oneok Does A Deal Nobody Needs), mostly because it forces MMP unitholders to pay taxes now that didn’t need paying and for some may never be paid. But we do agree with MMP CEO Aaron Milford that the growth opportunities in crude oil and refined products where they operate are not as attractive as in natural gas and natural gas liquids. Of course, MMP investors didn’t need him to sell the company because of that, anymore than a merger to create a more diversified business is justified. Investors can create their own diversification or high growth portfolio without M&A by management. But Milford’s not the only energy executive with the conviction that growth is more gassy and less oily.

Energy Transfer’s acquisition of Crestwood brings natural gas gathering and processing assets and reduces crude oil transportation to 20% of ET’s cash flows. This deal also doesn’t create any tax issues for owners.

TC Energy (TRP) recently announced they’re spinning out their liquids business to a be a standalone entity, leaving them to be an “opportunity-rich, growth oriented natural gas and energy solutions company.” They expect their liquids business to offer “incremental growth and value creation opportunities.” This doesn’t sound very exciting. TRP had been lagging its peers because of its high capex. The spinoff announcement wasn’t well received because it caused investors to think a little more about the liquids business and its low growth prospects.

Blackrock and KKR recently sold their stake in an Abu Dhabi crude oil pipeline for $4BN.

Most long term energy forecasts are political documents nowadays. If your projections don’t show a rapid transition away from fossil fuels, climate extremists accuse you of destroying the planet. BP struggled with this in recent years. They handed off their Statistical Review of World Energy to the Energy Institute last year. In 2022 their projections had the Orwellian names Accelerated, Net Zero, and New Momentum. The third was the realistic one showing current trends – the other two were useless for capital allocation.

The US Energy Information Administration (EIA) makes long term forecasts that fortunately remain apolitical. Forecasts of crude oil demand become increasingly tenuous over time because the transportation sector dominates and public policy can more easily impact the move to electric vehicles. But natural gas is harder to replace, especially in the industrial sector where the EIA sees Incremental growth for the next three decades.

The Inflation Reduction Act is encouraging Foreign Direct Investment (FDI). Dutch fertilizer company OCI is investing $1BN to produce ammonia, a key fertilizer input, in Texas. Europe’s declining energy consumption following Russia’s invasion of Ukraine is in part due to de-industrialization caused by high energy prices. Chemical, metallurgic, glass, paper and ceramic industries have been closing factories across Europe. In a recent survey of 3,500 German companies, more than half felt the transition away from Russian natural gas and towards renewables was “very negative or negative” for their business. Some of these companies are transferring output to America. Since 2021 the US has been the world’s biggest destination for FDI.

US exports of Liquefied Natural Gas (LNG) are almost certain to enjoy strong growth as the US adds LNG terminals to send cheap US gas to foreign markets. Industry and LNG exports are the two main drivers of growth for US natural gas.

Construction of new pipelines for both crude oil and natural gas in the US is far below past years and is unlikely to recover anytime soon. We have what we need. This is why growth capex is down more than half from its peak, boosting cash flow and making the stocks attractive.

The only major crude oil pipeline project under construction in North America is the expansion of the Trans Mountain Pipeline which Kinder Morgan wisely sold to the Canadian Federal government in 2018 (see Governments And Their Energy Policies). Getting its oil to international markets is regarded as being in Canada’s national interest. But the same environmentalist activism and cost inflation that delay private sector projects have similarly hurt this one now owned by the public sector. The estimated cost has increased 4X since KMI’s sale.

Recently engineering difficulties in an approximately one mile stretch of tunnel through a mountain in British Columbia have triggered a request for regulatory approval to alter the route. The indigenous population is opposed. Further delays look likely, risking “significantly increased construction costs.”

Gas is a growth business. Capital and M&A decisions are starting to reflect that.

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