Oil And Pipelines Less In Sync

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Oil And Pipelines Less In Sync
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The relationship between crude oil and pipelines exhibits the qualities of a copula distribution. This was suggested to us last week by a highly numerate financial advisor, commenting on the tendency of the midstream energy infrastructure sector to have its biggest falls when oil is also collapsing.

It is an unfortunate historical truth that a sharp drop in economic activity, such as at the onset of the pandemic, can depress both the price of oil and expectations for volumes of hydrocarbons passing through America’s pipelines. At such times investors recall being told it’s a toll model largely indifferent to commodity prices. This is true, but when commodities fall far enough it can signal a drop in volumes.

This is why the weakening relationship between the two is so welcome. Since mid-April Brent crude has shed $10 per barrel, while the American Energy Independence Index (AEITR) is close to unchanged. America’s regional banking crisis is one of the causes. Signs of the credit crunch are few, but a bank whose regulator is checking on their liquidity is likely to be trimming its risk appetite.

Construction loans would seem especially vulnerable. 350 California Street in San Francisco is expected to sell at an upcoming auction for 80% less than its $300 million 2019 appraised value. This will provide a useful benchmark for commercial real estate. Hybrid work has hit the Bay area office market especially hard. But the city also shows how much wreckage unchecked liberal policies can inflict. City leaders are considering a slave reparations bill that would award $5million to every eligible black adult, to be funded by the other 94% of the city’s population. A commensurate population shift will likely follow. California is contemplating something similar, at a cost of up to $800BN.

The decoupling of pipelines from crude oil relies in part on stronger balance sheets. The median Debt:EBITDA for investment grade companies is 3.5X. Ten years ago 4-4.5X was common. Most businesses are on a trajectory towards further reduced leverage next year, driven by increasing EBITDA.

Since the beginning of last year, daily returns of oil and the AEITR have a correlation of 0.45. They move together more often than not, but it’s a weak relationship. Following Russia’s invasion of Ukraine crude oil gyrated wildly while pipelines trended up. Crude was up over 50% by midyear, while the AEITR was +13%. During the second half of last year crude fell over 30% while the AEITR was +7%. So far this year they are down 5% and flat respectively.

The AEITR has also been helped by 1Q23 earnings, which followed a familiar pattern whereby companies generally beat expectations by a few percent. Cheniere is usually the exception, once again reporting a huge beat with 1Q23 EBITDA of $3.6BN (versus $2.5BN expected). They also raised full year guidance from $8-8.5BN to $8.2-8.7BN.

The energy sector is sitting on a growing pile of cash. This also acts to shield companies from movements in oil and gas prices. Exxon Mobil finished the quarter with almost $33BN cash on hand. Six big global oil companies have almost $160BN in cash.

Midstream companies tend not to accumulate cash to the same degree but are returning it to stockholders with dividend hikes and buybacks. Capex is creeping up in a few cases, but for the most part financial discipline remains.

The other day an investor asked me why riskless treasury bills yielding 5% weren’t better than energy infrastructure yielding 6% but with equity volatility. The answer is that treasury bills won’t always yield 5%, and interest rate futures imply they’ll be at 3% by the end of next year. Ample dividend coverage with the continued prospect of increases will lead more investors to this sector once the Fed starts cutting rates. Two publications from the Fed on Monday showed that they’re starting to appreciate the risk of regional banks adopting a more cautious attitude towards new exposure.

Bill Gross told Bloomberg TV that he has 30% of his personal portfolio in MLPs. He referred to Energy Transfer as an ETF (he was appearing on ETF IQ) and likes the tax deferred yields. His comments are at the 15 minute mark.

A fixed income investor likes the yield on pipeline stocks. Ten year treasuries at 3.5% are an improvement on the past few years but still inadequate to prevailing inflation.

It’s also interesting to see that NextEra, the most valuable power company in America and a leader in renewables, is planning to invest $20BN in hydrogen. The tax credits in the Inflation Reduction Act (IRA) are an important driver. But solar and wind projects are facing increasing challenges. Danish company Orsted, Spain’s Iberdrola and a JV including Shell are all developing offshore wind projects in New England and have requested a regulatory review of contracts because of sharply higher costs.

Weather-dependent power that requires enormous space and long-distance transmission lines is a miserable future. Hydrogen is expensive, although less so under the IRA. But like natural gas it’s energy dense and dispatchable, meaning it’s there when needed not just when it’s sunny or windy. And it can move by pipeline. Midstream energy infrastructure companies will be ready.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

 

 

Why Keep Money At A Bank?

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I looked through First Horizon Bank’s (FHN) 10K last week. They were in the news because Toronto Dominion (TD) canceled their merger agreement due to uncertainty about when they might receive regulatory approval. FHN’s stock slumped to below $10. The merger price, agreed in February of last year, was $25.

FHN CEO Bryan Jordan told CNBC that he had never been able to ascertain from TD the precise nature of the regulatory impediment that TD was facing. Nonetheless TD had second thoughts and regarded the $200 million break-up fee as better business than paying $13.45BN for a bank whose market cap is now less than half that.

FHN reported $1,159 million in pre-tax income last year, down modestly from 2021’s figure of $1,284 million. This excludes unrealized losses on their securities portfolio and hedges of $1,080 million, reported under Other Comprehensive Income. Including them would have wiped out the whole year’s profit. Perhaps this convinced TD to walk away.

When interest rates depress the value of bonds, banks don’t have to record unrealized losses as long as they have the intention and ability to hold them until maturity. Defenders of this approach argue that higher rates benefit the liability side of a bank’s balance sheet because deposit rates typically rise less than Fed Funds. Revaluing the assets and not the liabilities would present an inaccurate picture. However, it assumes the deposits won’t leave. Banks rely on history to assess the stickiness of their deposit base. Sometimes, as with Silicon Valley and First Republic, they’re wrong.

Deposits are sticky because savers are lazy or unsure how to access better rates using treasury bills. Banks are relying on this historic behavior repeating to fund their underwater bonds with uncompetitive deposit rates.

It costs money to provide banking services, and fees are highly unpopular. So in effect the fees are bundled into the service. Banks don’t pay much interest. That’s the fee.

Most of us weren’t watching while banks steadily loaded up on interest rate risk following the 2008 Great Financial Crisis (GFC). Quantitative Easing (QE) was intended to stimulate demand for capital by suppressing rates. But what’s good for borrowers can be bad for lenders. Many banks responded to low rates by increasing fixed rate commercial loans and mortgages. QE was supposed to encourage borrowing, but it also encouraged more long-term lending from banks.

FHN is a portfolio of underwater bonds and loans whose funding relies on uninformed depositors willing to leave money with them at low rates. Banks have always paid uncompetitive rates on savings. It’s part of the business model. It’s why banks traditionally do well when rates go up. FHN’s 10K shows that their Net Interest Margin (NIM) improves with higher rates. In 1Q23 earnings released on Thursday NIM deteriorated in spite of continued Fed tightening. And last year higher rates cost FHN over $1BN.

Like most banks, FHN assumes their deposits are unlikely to leave for higher rates elsewhere. But is that about to change? Silicon Valley caused people to ask two questions: (1) Is my money safe? (2) What interest is it earning?

The Fed has played a significant role in this. Because of QE investors and banks have faced unattractively low rates for years. The Fed was slow to recognize the risk of inflation. As a result, they raised rates faster than many expected. And they didn’t consider the impact on the banking system, which they regulate, of higher rates.

The Fed added to the pressure on regional banks by raising rates last week, further highlighting the uncompetitive rates paid on deposits. An increase in the FDIC cap above $250K would slow the outflow, but what banks really need is lower short term rates. Heavy reliance on large uninsured deposits isn’t every bank’s problem. But holdings of low fixed rate securities and loans are widespread.

America has over 4,000 banks. The figure has been declining for decades. We had twice that number in 1999. This abundance is a uniquely American construct, a legacy of state banking regulations which used to impede expansion. Often the small bank strategy was to be acquired by a bigger one. Today that’s only happening as a distressed sale. We’re learning that there aren’t 4,000 competent chief risk officers employed in the banking system.

Today, why would you deposit cash at First Horizon or indeed any bank beyond the amount you need to keep in a checking account? Fees are disguised as paltry rates on deposits. Banks have insulted our intelligence in this way for years. Rapid Fed tightening is illuminating it.

The market is priced for the Fed to provide banking relief in the form of lower rates, this year. The FOMC is in denial – slow as usual to comprehend what’s happening. The regional banking crisis won’t end until the Fed gets it. In the meantime, loan growth at all but the biggest institutions will be constrained by the risk of a rapid loss of deposits and recourse to wholesale funding in the Fed Funds market. Few banks can profitably fund their assets at 5%.

This is why you should bet on 4% inflation instead of 2%. It’s the path of least resistance.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

The Inflation Reintroduction Act

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The Inflation Reduction Act (IRA) may be the least appropriately named legislation in recent memory. That doesn’t detract from its impactfulness. Ever since its passage last summer, energy companies have been exploring ways to benefit from the uncapped tax credits and other subsidies available.

The IRA provided an improved tax credit of $180 per tonne under Section 45Q of the Internal Revenue Code for Direct Air Capture (DAC) of CO2. Occidental is building the world’s biggest DAC facility in Texas to extract CO2 from the ambient air and store it underground. They also increased the tax credit for CO2 that’s captured as emissions from facilities such as petrochemical plants to $130 per tonne.

Even CO2 used in Enhanced Oil Recovery (EOR) generates up to $85 per tonne in tax credits if it’s permanently stored underground. Tax credits for CO2 used in EOR does seem at odds with far left wing views of the energy transition but reflects a more pragmatic approach than some expected.

The Congressional Budget Office (CBO) estimated the expense of all these provisions at $3.2BN over a decade. Last year, when Credit Suisse was still expecting to thrive as an independent company, they estimated the cost of all these revised tax credits at $52BN.  Bloomberg New Energy Finance has estimated the cost could be over $100BN. Assuming a multiplier effect on government spending, Credit Suisse thinks the economic boost over a decade could be $1.7TN.

The tax credits are uncapped, so there’s no legislated limit on how high they can go. They’re credits not payments, which ordinarily would restrict their recipients to companies with a tax obligation. But the IRA allows the tax credits to be sold. Even though this would likely require a discount to face value to induce a transaction, the transferability greatly increases the pool of potential users and therefore the ultimate cost.

More recently, Goldman Sachs has estimated that the IRA will cost $1.2TN. Last year, Senate Democrats put the cost at $369BN. There’s a growing realization that the IRA represents substantial stimulus and will move the US towards lower greenhouse gas emissions. The IRA relies on incentives to reduce emissions, contrasting with the European approach which relies on penalizing emissions. Economists favor the latter. The US political system responds better to the carrot than the stick.

There are probably hundreds of companies that will benefit from the largesse of the IRA. Next Carbon Solutions is a division of NextDecade. They expect to be able to provide “end-to-end carbon capture and storage (CCS) solutions for industrial facilities.” They are planning to “partner with industrial facilities to invest in the deployment of CCS.” Management has even suggested to us that the carbon solutions business could be more important than the LNG facility they’re planning.

Another company that’s well positioned is Enlink. They recently signed a CO2 transportation agreement with a company in Louisiana. The Bayou state is the second largest industrial emitter of CO2, more than half of which comes from petrochemical and manufacturing businesses along the Mississippi River Corridor. Enlink already has an existing natural gas network that reaches this area and believes it can repurpose certain pipelines to carry CO2. They plan to gather gaseous CO2 and move it to central compression facilities where it’ll be converted to a supercritical state before being injected into appropriate geological formations. Many receptive rock formations exist in the area.

The improved 45Q tax credits in the IRA have made this a bigger opportunity.

In what seems like a regular occurrence, Cheniere raised full year guidance when releasing their 1Q23 earnings yesterday morning. Investors are becoming harder to impress; EBITDA of almost $3.6BN was $1.1BN ahead of consensus, yet the stock slumped 3%.

Enterprise Products Partners came in slightly ahead of expectations. Earnings for other energy infrastructure companies have provided few surprises, as is usually the case.

Meanwhile, Fed chair Jay Powell will hold a much-anticipated press conference following what most expect to be a 0.25% increase. JPMorgan advises parsing the FOMC’s statement to see if reference to “some additional policy firming” is changed to “any additional policy firming”. Such a revision would signify a pause in tightening. There still exists a wide divergence between the 2.9% yield on December 2024 Fed Funds futures and the 4% “blue dot” for that time from the last FOMC projection materials issued in March.

Inflation has been 1% or more above the Fed’s 2% target for two years, as we noted on Sunday (see Not Yet Cool Enough). Excessive Covid stimulus was part of the cause. The IRA shows that parsimony still has no place in setting US budget priorities. We think infrastructure offers some protection against persistent inflation.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Not Yet Cool Enough

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The regional banking crisis rolled on with two key developments on Friday. One was the release of several reports detailing the errors that led up to Silicon Valley Bank’s sudden collapse. Poor regulatory oversight combined with an absence of risk management were to blame. The other was the slow collapse of First Republic, which is turning out to be small enough to fail. Founder and executive chair Jim Herbert doesn’t sound as reckless as the team that ran SVB, but their equity looks to be similarly worthless.

Against this backdrop of regulatory failure and a banking system that has been caught out by higher rates, the Fed is about to deliver more of the same next week, taking short-term rates to 5%. December 2024 Fed Funds futures at 3% are priced for a 2% reduction by the end of next year. Reduced appetite for risk among regional banks worries the Fed less than the market.

Inflation’s return to 2% isn’t assured. Nominal GDP rose at 5% in 1Q23. Since real GDP was +1.1%, the price level is rising at a healthy clip. The 1Q23 Employment Cost Index (ECI) rose 1.2% versus 4Q22, and the prior quarter was revised up from 1.0 to 1.1%. We had thought year-end raises would be more reflective of recent inflation, overwhelming the seasonal adjustment, and this looks to have been true.  Compensation is up 4.8% year-on-year.

The Fed’s preferred measure of inflation, Personal Consumption Expenditures ex-food and energy (“core PCE”) rose 0.3% month-on-month and is up 4.6% year-on-year. We’ve now experienced two years of inflation above 3% (ie 1% above the Fed’s target). As the ECI figure showed, people are starting to adapt to inflation above 2%.

In the University of Michigan survey one year inflation expectations jumped to 4.6% in April, up from 3.6% in March. It’s been rising all year and is the highest since November. It’s hard to justify assuming 2% cost inflation for any big project or for retirement. Long term inflation expectations remain well behaved, but as consumers and businesses manage their affairs for near term inflation of 3% or 4%, it will keep upward pressure on prices.

As 3% becomes the new 2%, the Fed will continue to push back. It’s harder than usual to forecast confidently. The Fed may single mindedly pursue 2% and cause a recession, or the political blowback may force an eventual acceptance of a higher level.

We think midstream energy infrastructure is a good place to be in either scenario.

On April 21 the Federal Energy Regulatory Commission (FERC) reaffirmed prior approval of NextDecade’s proposed LNG export facility at Rio Grande, alongside a deepwater channel within the port of Brownsville, Texas. A Final Investment Decision (FID) should come within a couple of months. Last week their Chairman and CEO Matt Schatzman said, ““We have publicly disclosed that we expect to make it by the end of Q2.”

Building three “trains,” as LNG export facilities are called, is an $11-12BN project. The returns to equity investors will rely on successful execution and also on the mix of debt and equity the company adopts for financing. We still like the stock.

The Energy Information Administration (EIA) expects natural gas consumption to moderate in the years ahead as renewables gain market share in power generation. The need for permitting reform is illustrated by the Mountain Valley Pipeline’s continued failure to complete, held up by legal challenges to permits issued long ago.

Increased output from solar and wind also depends on a predictable approval process for infrastructure to move electricity. Solar and wind need wide open spaces and are generally not close to population centers. The EIA assumes new transmission lines will match increased output. Nobody wants their view sullied with electric pylons, especially if the electricity is merely passing by on its way elsewhere. Environmentalists are not a cohesive bunch, and every project will face objections.

However, even accepting the EIA’s rosy assumptions on vast grid improvements, increasing exports will drive improving economics for the owners of natural gas infrastructure. Russia’s invasion of Ukraine has created long term European demand for natural gas, competing with Asia and other emerging economies.

This outlook doesn’t depend on a defter execution of monetary policy than in the past few years. It does align with the desire of developing nations to consume more energy. If in time 3-4% inflation becomes the new normal, tariff escalators on pipeline tariffs linked to PPI and CPI will enable energy infrastructure to grow cashflows commensurately, if not better.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

Inflation vs Regional Bank Crisis

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This Friday’s inflation update will include the monthly Personal Consumption Expenditures (PCE) deflator and the Q1 Employment Cost Index (ECI). The Fed prefers the PCE because its weights are dynamic. When apples rise in price relative to oranges, CPI assumes no change in behavior, whereas some substitution towards oranges is to be expected. PCE picks this up.

Long term inflation expectations are remarkably low. The difference between treasury yields and TIPs is one measure of what investors expect consumer prices to do. By this measure, 2.3% inflation over the next decade is the market forecast. Since the next twelve months will be higher, expected inflation for the subsequent nine years is close to 2%. This is based on the CPI, since that’s the underlying index for TIPs. Since PCE inflation typically runs 0.2-0.3% below CPI, the Fed could declare victory anytime by noting benign expectations.

A few months ago (see Can Pay Raises Keep Up With Inflation?) we pondered the seasonal adjustment factors to the ECI. Most workers get annual pay raises around year-end. The seasonal adjustment factors will already pick this up. However, elevated inflation means higher annual raises than normal, so the seasonal adjustment factors may be inadequate.

JPMorgan is forecasting 1.1% for the Q1 ECI, up slightly from Q4 which was 1.0% after three successive declines. Interest rate futures continue to forecast that the Fed will be cutting rates by the end of the summer. The FOMC projection materials envisage a Fed Funds rate 1% higher than the market by the end of next year. Current market pricing is inadequate for a disappointment on inflation.

The Equity Risk Premium (ERP), defined here as the 2023 earnings yield minus ten year treasuries, sits below its 20+ year average. This measure shows stocks to be expensive. They’d need to drop at least 10% to put the ERP at neutral. This leaves the market vulnerable to higher yields.

Alternatively, the ERP could move higher to its long run average by yields falling. The ten year treasury would need to drop to 2.9%. Yields have been implausibly low for many years, so they could fall further. It’s not a bet we’d make.

The regional banking crisis and Silicon Valley Bank’s abrupt collapse caused a sharp revision in the rate outlook. Having worked in banking for much of my career, I can well imagine the anticipation of regulatory scrutiny that will cause all but the biggest (ie systemically important) banks to review their interest rate risk and reliance on large, non-FDIC guaranteed deposits. Simply the knowledge that interest rate risk will draw more questions than in the past will make many banks more cautious about extending fixed rate loans.

The sharp drop in Tier 1 capital as a percent of risk-weighted assets is another consideration that is likely to cause tighter terms on new exposure.

There are also signs that depositors are not being quite so tolerant of banks underpaying on deposits.

First Republic is the latest bank having to issue reassurances that they have ample liquidity – once you have to respond to such fears it’s usually too late.

The market expects banks’ reduced risk appetites and competition for deposits to hurt the economy. The Fed believes the broader economic risks are minor. Such differences are usually resolved at the costs of the FOMC’s forecasting reputation, but that already looks fully priced in to the futures market.

Bonds had begun to offer at least a modest return, but the recent drop in long term yields is moving the asset class closer to the returnless risk state that has prevailed for years.

Stocks aren’t cheap vs bonds, and while that implies fixed income is attractive, the Fed still owns $8TN of government debt from Quantitative Easing, so is distorting yields.

Behavioral finance teaches that investors often make mistakes due to overconfidence. It’s a human trait, and one more common in men than women I regret to say, that opinions about how many jellybeans are in a jar, sports outcomes and the year-end level of the stock market are held with greater conviction than they should be. Humility around one’s market forecast would seem especially important during current circumstances.

Earnings season is upon us, and we expect that it will reaffirm the solid position of midstream energy infrastructure companies. With dividend yields of 5%+, two times covered by free cash flow, improving leverage of 3.5X Debt:EBITDA and still low growth capex for most names, the prospects for this sector look more assured than for many others.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Renewable Energy Doesn’t Mean Clean

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A wood-burning fireplace on a cold day is a welcoming sight. The crackle and smell of combusting organic matter has provided a place for humans to bond for millennia. Coal replaced wood as the developed world’s chief source of energy in the 19th century. Because of this some feel a misplaced sentimental attachment to burning firewood. Environmental extremists pursue policies intended to return living standards to pre-1850, before the onset of the industrial revolution with its increase in anthropogenic (ie human-generated) CO2. So it’s not surprising that they’d favor that era’s main energy source.

Coal displaced wood for fuel because it was more efficient. Coal is more energy dense, so generates more BTUs by weight. The ratio depends on the type of coal and wood being compared, but 2X is a fair approximation.

Wood also generates lots of fine particulate matter. That fireplace is cozy, but it’s also a toxic environment. The US Environmental Protection Agency warns of the dangers presented by wood smoke, especially indoors. It’s a big source of pollution and respiratory problems across Africa and in other developing nations where wood is commonly used for cooking and heat. The UN has initiatives aimed at reducing the pollution and CO2 emissions from poor families using wood.

There is plenty of evidence that burning wood is bad for the planet. Left-leaning outlets such as NPR and the UK’s Guardian have been critical.

Nonetheless, the world is burning more wood to generate power, especially in the UK and EU. Fuzzy math in accounting for the CO2 generated from using wood pellets to produce electricity classifies it as clean energy. This means their CO2 emissions aren’t counted. The US is the largest exporter of wood pellets, often sourced from forests in the south east. Canada is #3. The UK is by far the largest importer.

The companies that produce and consume wood pellets seem to be exploiting a hole in the EU’s climate change policies (known as RED II).

Wood pellet producer Enviva argues that wood pellets are produced from fallen branches that would otherwise sit on the forest floor and decay, or that only trees cut down for “thinning” a forest are used. But drone footage and Enviva’s public filings show that they’re using freshly cut trees.

Drax runs the UK’s biggest power station, and thanks to £6BN of UK taxpayer subsidies converted a coal burning power plant to run on wood pellets that provide 12% of the UK’s “renewable” electricity. A BBC documentary found that Canadian forest was being cleared and used for wood pellets.

Trees are nature’s way of absorbing CO2 – research shows that global CO2 levels fluctuate with the seasons. A felled tree stops absorbing CO2, and burning it releases the CO2 it held. Apologists argue that by replanting new trees in the same forest they’ll suck those emissions back in. But researchers at the Massachusetts Institute of Technology have concluded that not only does wood burn dirtier than coal, it takes at least 44 years for replanted trees to absorb the carbon released from burning the ones they replaced.

It seems so obvious that chopping down trees to produce electricity is a dumb idea. Because trees grow back again wood pellets are classified as renewable. That doesn’t mean they’re clean. But since the EU and UK have legal requirements to lower emissions, they’re resorting to slick accounting because solar and wind aren’t going to do it.

It’s too early to say whether the Inflation Reduction Act’s subsidies for biofuels (the catchall within which wood pellets sit) will encourage the same perverse policies the UK has pursued here in the US.

Sometimes it seems as if the lunatics are running the asylum.

My thanks to good friend Mike Shinnick of Naples, FL for bringing this topic to my attention.

Kinder Morgan (KMI) reported earnings last week. They were ho-hum. The quarterly dividend was raised by 2% to $0.2825. A decade ago then-CEO Rich Kinder reacted angrily to criticism from Kevin Kaiser, then at Hedgeye. But within a couple of years they slashed the dividend from $0.51 to $0.125. KMI has an attractive 6% yield because they have a long and mediocre record of capital allocation, which is why the dividend is only slowly recovering.

However, in the press release current CEO Steve Kean, who will soon step aside for CFO Kim Dang, commented on the continued failure of Congress to deal with reforming infrastructure permitting. Kean added that the difficulty in building pipelines in America, “…increases the value of our existing natural gas pipeline systems, which results in a favorable recontracting environment.”

The continued delay in completion of the Mountain Valley Pipeline is frustrating Senator Joe Manchin and is the best example of what’s broken. However, the environmental extremists whose court challenges are the cause are unwittingly increasing the value of existing infrastructure. This is another reason why it’s a good time to be a pipeline investor.

Climate extremists aren’t always deep thinkers in the policies they pursue, but they’re not all bad. If you meet one, give them a hug and offer a drive to their next protest.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

Some Banks Are Having To Pay More

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I’m the treasurer for our co-op in Naples, FL. I recently asked our local bank to pay a more competitive rate on our cash balance, which is well over the $250K FDIC insurance limit. Their deposit rate for business accounts was 0.5%, and maybe because Silicon Valley Bank (SVB) had just failed they quickly raised it to 3%.

This is still inadequate, and I’m not done with them yet. Banks are notoriously sluggish in raising rates when the Fed’s tightening. Depositors are slothful in demanding competitive rates. The margin below treasury bills can be thought of as the fee for banking services, although the cost in foregone interest income is more than most depositors would tolerate if asked to write a check for the amount.

Banks don’t make it easy either. Parking cash in treasury bills requires a brokerage account and the ability to easily move money back and forth. Dual sign-off for transactions is often required on business accounts. It can quickly become an administrative headache to earn a competitive rate, and banks know this.

SVB’s failure exposed imprudent risk management, but it prompted depositors to consider where their money sits and what it’s earning. Money has flowed out of regional banks, some of it to the systemically important banks (“too big to fail”). We assume deposits are fully guaranteed even though they’re legally not. There’s a de facto guarantee because allowing depositors to suffer a loss in bankruptcy might lead to another financial crisis. Size matters. A bank deemed small enough to fail is not the place to be.

Extending FDIC insurance requires legislation, so Treasury Secretary Janet Yellen makes confusing pronouncements. Unable to explicitly guarantee every deposit, she nonetheless leaves the impression that she would.

There are increasing signs that regional banks, those not deemed too big to fail but nonetheless enjoying an implicit guarantee of their deposits, are being squeezed on both sides. They’re being forced to offer depositors higher rates, since their customers are no longer as slothful. SVB’s failure started with customers leaving for higher rates.

On the asset side, the banking system’s increasing duration risk has become problematic given the Fed’s rapid tightening. SVB’s reach for yield ultimately rendered them insolvent. Although they were an outlier in unsecured deposits and interest rate risk, markets and regulators are now pondering the unrealized losses in bond portfolios across the system. Sticky deposits are normally believed to have increased in value when rates rise because of the lethargy with which banks increase the rates they’re paying. But today’s altered dynamic looks likely to force more competitive practices on banks.

Schwab is a good example. Last year they changed their default option for client cash balances to Charles Schwab Bank rather than money market funds. This allowed them to pay low rates and invest the cash in bonds, picking up the spread. This is similar to SVB, but Schwab wasn’t as reckless.

Nonetheless, in their earnings on Monday Schwab revealed that the size of deposit outflows had caught them by surprise, forcing them to borrow money at wholesale rates to fund their bond portfolio. Banks have long argued that revaluing their assets down in response to higher rates without recognizing the implicit higher value in sticky deposits presents an unfair, biased picture. But the problem is that the long duration of liabilities isn’t contractual, it’s just assumed based on history.

Commercial and Industrial loans have dipped in the past several weeks, a first sign of risk appetites being reined in. Banks know regulators will look more closely at duration risk on securities and loans, casting a chill on their willingness to extend credit.

This is what’s behind the gap between where the market expects Fed policy to go and the FOMC’s projections. Tighter financial conditions have increased recession risk. Such differences are usually resolved at the cost of the FOMC’s reputation for forecasting accuracy.

On a different topic, Texas is confronting the problems that come with being the leading state in windpower generation. Storm Uri in early 2021 that caused widespread power outages led some renewables champions to note that natural gas plants stopped producing along with windpower, and that it was incorrect to blame the debacle on intermittent power.

Nonetheless, the Texas state legislature has concluded that more natural gas power plants are just what is needed to prevent a repeat. Having subsidized windmills they’re now going to subsidize reliable power to stabilize the grid. The intermittency of solar and wind creates problems for systems that become too dependent on them. Note that they didn’t opt to invest in battery back-up to compensate for this shortcoming. Instead, lawmakers in Texas have concluded that reliable, dispatchable power is what’s needed.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

So Many Pessimists

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Why are people so negative? A recent WSJ article included results to the yes/no question: “Do you feel confident that life for our children’s generation will be better than it has been for us?”

78% of respondents said no. They think the next generation will be worse off. This is the most negative reading in over thirty years of the question being asked. America is a nation of positive, can-do people. I knew that when I moved here 41 years ago. In Britain, where I grew up, the response to challenges is often one of resignation. In America we get mad – like in the 1976 movie Network. “I’m as mad as hell, and I’m not going to take this anymore!”

By objective measures such as incomes and longevity the next generation has been doing better than prior ones for at least the past couple of centuries. To expect this to change is to bet against a well-established trend.

It’s possible to interpret the answers differently. The four fifths who think the next generation will be worse off than us may be so giddily happy with present circumstances that any further improvement is inconceivable. This is being negative in a positive way, and if true would reflect a warm, optimistic outlook.

But it’s not supported by other surveys. For example, the University of Michigan index of consumer sentiment goes back to the 1950s and is very negative. The more plausible interpretation is that many people feel life sucks and it’s going to get worse.

Why do people feel like that? Jobs remain plentiful. We’re not at war. The pandemic is over. Things have been worse. Inflation has lowered real living standards, but it’s declining without the economy falling into the perennially forecast recession.

Maybe it’s our increasingly partisan politics which affords extremists in both parties outsized influence.

In March 2020 the pandemic was unfolding. We didn’t know how deadly it might be and dire comparisons were made with the Spanish flu of 1918. We were under the tyranny of lockdowns. Equity markets, especially energy, were collapsing. That was a moment when negative feelings about the future were understandable.

And yet, consumer sentiment was higher than it is now.

Economically, America is hitting it out of the park. The Economist gushes that, “The world’s biggest economy is leaving its peers ever further in the dust.” We’re 58% of G7 GDP compared with 40% in 1990. Even though China has grown enormously, our share of global GDP is roughly unchanged over the same period. Average incomes in Mississippi, America’s poorest state, are higher than in France adjusted for purchasing power. Tell anyone who thinks the American economy is in poor shape that they could be worse off – they could live in the EU.

The 2008 Great Financial Crisis, 1990-1 first Iraq war and recession and the 1979 Iranian capture of US embassy staff were all times when consumer sentiment was understandably negative. People feel as downbeat as at those times, if not more so.

Maybe we just expect more out of life.

Among our family archives is a series of letters sent from the field hospital in northern France where my great grandfather, Harry Lack, lay dying of wounds during World War I in 1917. The letters were sent by the head nurse to my great grandmother, recounting how fondly her husband was talking about her and their baby boy. 84 years later I read them for the first time sitting next to my grandfather, who never met his father. Consumer sentiment wasn’t measured then, but low readings wouldn’t have been shocking.

There have been plenty of times in American history where the outlook wasn’t as bright as it is today.

The Economist warns that “…the more that Americans think their economy is a problem in need of fixing, the more likely their politicians are to mess up the next 30 years.”

There is one meaningful and tragic negative: life expectancy, which fell in most countries during Covid, has continued to deteriorate in the US by contrast with other rich countries. Even more troubling is that young people are dying. Only 24 out of 25 five-year-olds in America can expect to turn 40, a shockingly high fatality rate 4X that of peer countries. Drugs, notably opioids, are behind this. School shootings are probably another factor since gun violence is now a bigger cause of death among children than automobile accidents. By contrast, older Americans enjoy life expectancy similar to peer countries.

Negativity over too many young people dying could be forgiven if that was driving morose feelings. But there’s not much evidence that it is the main cause. Moreover, we can solve this problem ourselves as we have so many others in the past.

I moved here from the UK in 1982 drawn by Americans’ sunny optimism, epitomized by my first president Ronald Reagan. To this immigrant, the country’s prospects look at least as bright as they did then. The only political ad in history worth rewatching is It’s Morning Again in America from Reagan’s 1984 presidential campaign. It’s always morning in America.

Don’t be swayed by negativity. America’s best days are still ahead.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Political Energy

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FERC recently approved a request by Williams Companies to expand its Transco natural gas pipeline in New Jersey. As is usually the case, environmental extremists have been opposing this and other enhancements to the state’s energy infrastructure even though Williams, a commercial enterprise, is presumably meeting increased demand for its services.

Of the seven fossil fuel projects opposed by fringe extremist group Empower NJ, the one that residents surely most strongly support is the proposal to widen 60 miles of the NJ Turnpike and 64 miles of the Garden State Parkway. New Jersey is the most densely populated state in America at 1,259 people per square mile, not far behind the Netherlands at 1,355.

America has vast open areas, but not in the northeast. The situation is not helped by liberal policies that promote high-density, low-income housing. It’s likely that the people opposed to reliable energy like Empower NJ are the same ones who believe everyone who wants a home in New Jersey is entitled to one, regardless of whether that creates even more traffic on our major freeways and need for infrastructure.

Widening our highways is scarcely a fossil fuel project, and is necessary because, improbably, people keep moving to the state. Nonetheless, population growth lags the rest of the country. Therefore, New Jersey’s Congressional representation has been shrinking too. Anecdotally and otherwise it’s clear high earners, who are also high taxpayers, are leaving for states where the weather and politics are sunnier.

Empower NJ opposes expansions to the state’s natural gas infrastructure. Williams Companies recently won FERC approval to add 829 Mcf/Day of capacity to their Transco pipeline network. Empower NJ wants Governor Phil Murphy to block the Transco expansion mentioned above and other important projects. Although the governor may step in, so far he hasn’t. To be left of NJ’s governor is to be truly on the fringe of coherent thought.

Meanwhile, Goldman Sachs estimates that the mis-named Inflation Reduction Act (IRA) will cost $1.2TN, more than three times the CBO’s estimate. Energy companies are rushing to create business lines that will benefit from the many tax credits.

The promise of enormous tax credits in the IRA has boosted lobbying efforts by the energy sector, which had been falling for several years. Pharmaceuticals spend more, but the gap is closing.

Climate extremists have long promised with no empirical evidence that solar and wind are cheaper than natural gas. If this was the case our power supply would be dominated by renewables, which it isn’t. The tax credits in the IRA should make intermittent energy so appealing that further investments in oil and gas must offer extraordinarily compelling returns to compete.

Occidental’s Direct Air Capture (DAC) plans were covered recently in the WSJ. They’re building the world’s biggest DAC facility in Texas and plan to add dozens more. DAC has its critics, who contend that the 0.04% concentration of CO2 in ambient air makes capturing it uneconomic.  Occidental’s ambitions extend to selling carbon credits to businesses that can’t reduce emissions (such as airlines). The IRA provides tax credits of $180 per ton for DAC CO2 permanently sequestered underground.

Groups like Empower NJ, more properly named DePower NJ, are pursuing a philosophy of making life miserable for everyone by impeding needed expansions to reliable energy. They lament completed projects such as new gas power plants and pipeline enhancements. They’re trying to foist on us the dysfunctional policies of Massachusetts and New York where access to natural gas is impeded but still needed.

The surest way to lower emissions is to use less energy, most effectively achieved by shrinking NJ’s population. Empower NJ could perform a great service to the Garden State by relocating their dystopian supporters out of the state.

The charts below provide a helpful reminder of key points in considering the world’s use of energy.

China is by far the biggest user of coal, the most prolific source of greenhouse gases. Meaningful progress on climate change won’t happen without China’s participation. Energy consumption has never fallen in human history, yet UN forecasts showing emissions falling assume this will happen.

Output from renewables has an unfortunate tendency to slump during extreme weather when it’s most needed.

Higher renewables penetration equals more expensive electricity. This may be a price worth paying to reduce emissions, but climate extremists ignore it.

Daily power demand follows a predictable cycle, peaking around dinner time. Solar peaks at noon. Wind is unpredictable but is often highest at night.

Solar and wind contribution to total power generation varies widely and unpredictably. The challenge this creates for grid operators balancing supply with demand increases sharply with more renewables.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Europe’s Liberal Energy Policies Costs More

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I was in the UK recently where reducing emissions to zero by 2050 is now law. In spite of the conservative populism that drove Brexit, Britain is a politically liberal place from the eyes of this visitor who last lived there 41 years ago. Illegal immigration is a worldwide problem, and the British face African and Asian refugees crossing the English Channel from France in flimsy boats. The government estimates 45,700 such arrivals last year in the Explanatory Notes to proposed legislation (the Illegal Migration Bill).

The new law would compel deportation back home or to Rwanda which is deemed a “safe third country.” Left-wing critics contend that the country should be more welcoming. Former English footballer Gary Lineker, who now analyzes games on the BBC’s Match of the Day, was briefly taken off the air for equating government policy with Nazi Germany. The middle ground in the UK debate over illegal immigrants and refugees is left of the US. New York City is considering repurposing the Javitz Convention Center to house asylum-seekers, many of whom have been bused north from Arizona and Texas.

Wind power contributed 27% of the UK’s electricity last year. Dozens of wind turbines are visible from the windy coast of Kent in the English Channel where on a clear day you can also see France. They extend up into the North Sea and are all around the country. The UK’s 28.8 Megawatts of wind capacity generated just over 80 Gigawatt Hours of power last year, meaning they ran at about 32% of capacity. This is within the normal range for offshore wind, although a visitor to the blustery English seaside would be forgiven for assuming they generate power more or less permanently.

Although the high renewables share sounds good, wind only supplies 3.3% of Britain’s primary energy because there’s more to modern life than electricity. Fossil fuels provide 81%. In his recent Annual Energy Outlook, JPMorgan’s Mike Cembalest thinks of two energy transitions: (1) decarbonizing electricity generation, and (2) electrifying energy consumption. The world is doing better at (1) than (2).

Electricity is expensive in Britain, because renewables are expensive and because they have to import Liquefied Natural Gas (LNG) at prices that compete with Europe’s failed energy policies. But public opinion generally supports the energy transition.

Across the North Sea, the Netherlands relies on fossil fuels for around 80% of its total energy, about the global average. Wind is 4.9%. We recently spent a couple of days in Amsterdam, a city whose downtown is for walking. Pedestrians face greater risk from the cyclist’s silent approach than from automobiles. Bike lanes are common, although cyclists rarely pause at stop signs or crosswalks.

Europe’s mild winter prevented a shortage of natural gas, but next year presents a bigger problem since Russian gas will no longer boost supplies as it did in the first half of 2022. European prices have plummeted from last year’s high but remain double their pre-war level. There are signs high energy prices are causing a shift in manufacturing to other countries, including the US.

Like much of Europe, Massachusetts imports LNG which exposes them to high global prices. The Bay State has rejected pipelines that could deliver gas cheaply and safely from Pennsylvania because some climate extremists think impeding access to gas will stop its use. Others prefer the lights to stay on, so an LNG tanker recently docked in Boston from Trinidad and Tobago. In January 2022 New England households paid 22.9 cents per Kilowatt Hour  (KwH) of electricity. For all of 2022 the UK averaged 18.9 pence (23.4 cents) per KwH. Higher natural gas and increasing use of renewables mean both are paying more now. UK households expect to pay 34 pence (42 cents) this year.  And that’s only because of a government imposed price cap. The actual price is forecast to average 52 pence (64 cents) per KwH. New England is at 29.7 cents.

The US average is 15.5 cents. Even in liberal New Jersey we only pay 16.9 cents, although Democrat governor Phil Murphy is pursuing policies designed to push this up, such as opposing an expansion of natural gas pipeline capacity planned by Williams Companies and approved by FERC.

For cheap, reliable power natural gas is the solution. Even Texas, which produces more electricity from windpower than any other state, is planning to invest $18BN in natural gas power plants to reduce the risk of another grid failure like the one two years ago.

Florida households pay 15 cents per KWh. Florida Power and Light promotes its growing use of solar but is also reducing rates modestly because of falling natural gas prices. My family and most of my friends are in New Jersey, but you wouldn’t want to start a business there. Florida is a better run state.

Europe’s energy policies, which impose most of the cost of the energy transition on households, explain most of this difference. The embrace of fracking, almost unique to the US as a method of oil and gas extraction, has created our abundant and cheap natural gas.

Your blogger’s recent trip to London included two English Premier League games, at Arsenal and West Ham, seeing old friends and a short visit to Amsterdam. I am now rejuvenated and back in the land of more conservative politics and (mostly) cheap energy.

 

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

 

 

 

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