• Our reflation outlook for the US and Europe in 2022 is alive and well despite a recent decline in leading indicators. We expect automobile semiconductor production to double by next summer compared to its recent pace; Eastbound freight rates highlighted in our September piece are finally dropping, along with a large decline in the Baltic Dry Index of shipping costs; we expect a return of ~2 mm people that left the US labor force by Q1 2022; and there are reports of falling backlogs and rising factory utilization rates in Asia as vaccination rates surpass 60% in Vietnam and Thailand, and surpass 70% in Malaysia and Taiwan
• US and European GDP should get a boost as supply shortages eventually dissipate and as inventory levels are rebuilt from very low levels relative to sales, which are still holding up well; and as US infrastructure and reconciliation bill spending eventually gets deployed
• Even with supply constraints, US and European firms have posted another quarter of high margins, earnings and sales vs expectations (see table below). Also, it looks like top US statutory corporate tax rates will not rise, and that changes will include higher taxes on foreign income, a 15% minimum book tax and a 1% stock buyback tax. The net impact looks like a 3%-4% earnings hit to the profitable US tech sector, and at most a 1.0%-1.5% earnings hit to all other sectors
• US labor shortages will be endemic, however, in part due to the US having one of the largest unvaccinated populations in the developed world and due to a COVID-driven surge in retirement. This creates the risk of wage-price spirals that are out of sync with current Fed policy. It also creates margin pressure on labor-intensive firms (Consumer Discretionary and Staple stocks); but most S&P 500 market cap labor intensity is much lower (Tech, Healthcare, Internet, Energy, Utilities, Financials)
• China is the growth outlier, suffering a demand shortfall due to a combination of energy constraints, a regulatory purge, only modest easing of monetary and financial policy and among the strictest COVID protocols in the world

The Thing

“In all my years I never heard, seen, nor smelled an issue that was so dangerous it couldn't be talked about”

Stephen Hopkins, Governor of Rhode Island and signatory to the Declaration of Independence, 1776

Until this year, I had never run into a topic that I couldn’t write about. Anything affecting markets, economics or growth was fair game, and a lot of controversial topics show up in the Eye on the Market archives since its launch in 2003 (see page 4). But now I have run into such a thing, and I still don’t think I can write about it. My guess is that you know exactly which topic I’m referring to.

Anyway, here’s a different topic that I can discuss. There are some strange things going on in energy markets; Massachusetts, California, Europe and China provide some cautionary tales below. The bottom line: if you reduce the supply of fossil fuels faster than you reduce the demand for them, you’ll end up with a combination of higher energy prices, energy dependence that can border on servitude, and inadequate supplies that can lead to power rationing of homes and businesses. The chart below shows energy dependence by region. As the US moves forward on its renewable energy journey, policymakers should pay attention to mistakes made elsewhere in order to avoid losing the hard-fought energy independence that has taken 50 years to achieve.

Massachusetts: in the progressive enclaves of the Northeast, NIMBYism continues to kill decarbonization.  Maine has followed New Hampshire in blocking a high voltage transmission line needed to bring hydropower from Quebec to Massachusetts, requiring New England’s ISO to expand its reliance on natural gas instead.

California has already experienced rolling blackouts due to power demand that exceeded planning targets, and that’s before the state decommissions 2,250 MW of nuclear power and 3,700 MW of natural gas fired power plants in the next couple of years.  California has among the highest solar irradiance levels in the northern hemisphere, comparable to Southern Spain and Northern Africa; its offshore wind speeds are even higher than the Central Plains states; and its 1,800 MW of geothermal power represents 75% of US capacity, an indication of the state’s favorable geology.  And yet California still imports power from adjacent states, although even this is now at risk as neighboring states shut down coal-fired plants whose generation was sold to California.  The state plans to store excess renewable generation in utility scale batteries but this will take time, so the state approved the temporary use of four natural gas generators to alleviate the power shortage.

Europe is facing a long winter with natural gas supplies 10%-15% below normal for this time of year.  At the same time, Russia is offering only a small amount of gas to Europe to alleviate the crunch, and has only offered 15%-20% of 2019 spot market volumes to Europe for the years 2022 and 2023.  A few reasons: last year, Russia had an unseasonably cold winter and its winter looks to be starting early this year; Russia is having trouble filling its own domestic natural gas reserves; Russia spent $11 billion on Nord Stream 2 and is trying to maximize returns on it by pressuring Europe to approve it; and Russia made it clear in advance that it prefers long term take-or-pay contracts rather than selling in the spot market

China’s energy crisis is complex but is another example of fossil fuel supply falling faster than demand.  Contributing factors: a surge in Chinese power demand in 2021 as the global economy rebounded; lower China hydropower output which increased demand for coal fired power; a slowdown in China coal production due to climate goals, safety concerns and a coal price cap, leading to power plants running down coal inventories way below normal levels; disruptions in Indonesian coal exports due to heavy rains and domestic prioritization; and price controls in China’s power sector which prevent utilities from recovering rising input costs

The next chart shows Europe’s “servitude convergence gap”:  Europe now imports around as much oil and gas from Russia as it produces for itself[1].  The US does not face a servitude gap, but mounting pressure on investors and lenders to starve the oil & gas industry of capital could eventually change that[2].   As per our assumptions outlined in detail here, the US might need roughly the same amount of natural gas in 2035 as it uses today.  If that’s right, the only remaining questions are whether this energy is produced in the US or imported from Canada, Qatar and Russia, and how that affects reliability of supply, price and national security.

Meanwhile, for investors, the fundamentals of traditional energy companies look quite different than they have in many years.  Capital spending has collapsed vs depreciation and cash flow, and the industry is earning record high free cash flow margins.   With that I wish all of you, and in particular Rachel[1], a Happy Thanksgiving.

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Vivamus consectetuer risus et tortor. Lorem ipsum dolor sit amet, consectetur adipiscing elit. Integer nec odio. Praesent libero. Sed cursus ante dapibus diam. Sed nisi. Nulla quis sem at nibh elementum imperdiet. Duis sagittis ipsum. Praesent mauris. Fusce nec tellus sed augue semper porta. Mauris massa. Vestibulum lacinia arcu eget nulla. Class aptent taciti sociosqu ad litora torquent per conubia nostra, per inceptos himenaeos. Curabitur sodales ligula in libero. 

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• Morbi lectus risus, iaculis vel, suscipit quis, luctus non, massa. Fusce ac turpis quis ligula lacinia aliquet. 
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• Nam nec ante. Sed lacinia, urna non tincidunt mattis, tortor neque adipiscing diam, a cursus ipsum ante quis turpis. Nulla facilisi.
• Ut fringilla. Suspendisse potenti. Nunc feugiat mi a tellus consequat imperdiet. Vestibulum sapien. Proin quam. Etiam ultrices.
• Vestibulum lacinia arcu eget nulla. Class aptent taciti sociosqu ad litora torquent per conubia nostra, per inceptos himenaeos.
• Curabitur sodales ligula in libero. Sed dignissim lacinia nunc. Curabitur tortor. 

¹ "Morbi lectus risus, iaculis vel, suscipit quis, luctus non, massa

² Duis sagittis ipsum. Praesent mauris. Fusce nec tellus sed augue semper porta. Mauris massa.