Long-term treasury yields

Bill Ackman has made the news about being short 30-year treasury bonds (buying puts on treasuries). You can play this trade at home too, by buying puts on TLT – at the money on long-dated options is trading at an implied volatility of about 16.5% right now. The below chart is the 30-year treasury bond yield.

There have been other prominent people in the Twittersphere piling in (e.g. Harris Kupperman) on the risks of long-term interest rates rising – it’s one way to flatten the yield curve with the short side going longer, it’s another thing completely for the long end of the curve to go up.

In general, when more people are conscious of a particular direction of trade, the riskier the trade becomes. Both Ackman and Kupperman are “talking their book” at this point, the question is whether they were at the beginning of this wave, or whether it’s mid-crest. I’m not sure.

My lead suspicion from a macro perspective is that the market is catching wind that the US Federal Reserve is not going to let up on short term interest rates anytime soon, coupled with the US Government’s Treasury issuing tons and tons of debt financing after Congress approved the rise in the debt ceiling – the US Government is raising a huge amount of cash. Economic data is too strong and employment is surprisingly resilient (with resultant wage pressures). We still see way too much speculative impulses in the market (for a good time, look at American Superconductor – AMSC on the Nasdaq).

What you’re seeing as a result of slow quantitative tightening, the US Government being the first claim on US currency (the treasury auction IS the price on money), and continually rising interest rates is a liquidity drain. As the liquidity gets sucked out of the system, the continual demand for money (the least of which to pay interest on debts) will result in a higher cost of money until the Federal Reserve decides to stop. Because so many have speculated about “the pause”, it blunts the effect of rising interest rates and hence the need to raise rates and tighten liquidity further.

Let’s take the Kupperman scenario of long-term rates going to 600bps, which means a risk-free P/E of 16.7 for significant duration. I’ve pointed out in the past that the risk-free rate is competing significantly against equities and this competition gap will continue to get wider and wider. We would surely see equities without earnings power depreciate. We would also see higher incumbency advantages in capital-intensive existing companies. I also think it would be the straw breaking the camel’s back with certain REITs which are already on the financing bubble (look at my previous post about Slate Office).

The question is whether the US Government, currently printing off massive deficits, would actually be able to taper their spending or whether this leads to another conclusion that we’re going to see massive levels of inflation, much more so than we previously have seen. Will we get to the point where we see defaults and a credit crunch?

Either way, it leads to a similar conclusion – keep a bunch of dry powder (cash) handy for buying into blow-ups that won’t go into Chapter 11 or CCAA. The 5.5% or so of short-term risk-free money is better than nothing, although I too even think this is a crowded trade. For large-cap investors out there, an example of an opportunistic miniature blowup was TransCanada (TSX: TRP) a few days back – although something makes me suspect you’re going to see it go even lower than $44/share in the upcoming months. There are going to be plenty of further examples like this going into the future of companies facing issues with debt.

Enbridge Line 5 and pipeline politics

It is going to be very interesting to see what happens with Enbridge and Line 5.

The reason why the Federal Government cares about keeping Line 5 operational is because it processes about half of the crude oil that is refined for southern Ontario and Quebec. You can take a car to Sarnia and see the refineries.

A shutdown of Line 5 would, needless to say, be very disruptive for the region. There isn’t a good way to get additional capacity into the area – the other routes are fully utilized.

The federal government only cares about what is good for, roughly, the traditional boundaries of Upper and Lower Canada. Any policies that are tailored for areas away from this geography is strictly coincidental.

Thus, the Keystone XL cancellation was of little concern to Ottawa. The usual lip service of condemnation by politicians, when it is so obvious they don’t mean it.

I am still somewhat mystified today that the federal government bought out the Transmountain pipeline project – most people do not know that there is an existing (profitable) pipeline in place. Its existence does not matter an iota to Ottawa.

Line 5, however, is different. It fuels Ottawa’s core geography.

It was not longer than a decade ago when this strategic and political vulnerability was identified and hence the Energy East project was conceived. After the Liberals got into office in October 2015, they proceeded to kill the project with a never-ending wall of regulation.

We fast forward today and see where such lack of strategic thinking is par for the course in Canada.

It is not my job to moralize about the inadequacies of government thinking, but rather to pick out winners and losers.

I am still puzzled why so many people are in love with Enbridge as being a staple in their yield portfolios. There is far more risk than they imagined.

The sentiment will change when there is a real connection between very poor decisions and actual hardship experienced by people. The lag between the two, however, could take many, many years and attribution of blame may be misdirected.

Likewise, few lament over how much richer we could have all been, collectively as a society, had we had our act together to begin with.

Politicians, however, are not rewarded for making optimal or efficient decisions. In fact, they have a gigantic incentive to not solve problems, lest their purpose of existence be threatened.

Mid-stream oil and gas

Low oil prices hurt producers for obvious reasons.

They also are hurting the mid-stream, but this is for less obvious reasons – low prices means curtailment of capital expenditures, which typically mean lower volumes, which means less money for midstream producers. Volume is the dominant variable for the mid-stream, not prices.

The flip side of this equation is lower prices stimulates consumption, which means higher oil prices, which means higher capital expenditures… you get the picture. There is an equilibrium factor that depends on mutually dependent factors in order to “solve the equation”. In Excel, this would typically be a circular equation, but when applied in real life, the input variables are much more fuzzy, and thus it makes the output chaotic and difficult to predict where the true “landing spot” is (which never exists – it is always ever-moving).

The other clear factor is that when oil and gas companies are not making profits, there is an element of counterparty risk.

One broad-brushed way of investing in the US mid-stream sector is through the Alerian MLP ETF (AMLP) which got killed yesterday. The constituent companies are fairly stodgy oil and gas pipeline MLPs which give out most of their income in the form of distributions. Normally MLPs are very adversely taxed for Canadians, but the AMLP structure is a corporation. It distributes its income mostly in the form of a return on capital, but for tax purposes, it is equivalent to foreign income. However, in a registered account, this is a non-factor. At the low of $4.14/unit, it was trading at a yield of 18% and even when factoring in the inevitable decline of shale production in the USA, seems to be a reasonable risk-reward proposition as investors seek yield.

To a lesser degree, Canadians can also invest in Enbridge (TSX: ENB), TransCanada (TSX: TRP), Pembina (TSX: PPL), and for those interested in Albertan intra-provincial pipelines, Inter-Pipeline (TSX: IPL). However, the income to price disparity is not nearly as present as the American analogs (including Kinder Morgan, Williams, etc.).

Pembina, in particular, has gotten killed simply because it faces a risk that the Trans-Mountain pipeline is not going to be constructed, especially with the crash in oil prices and the general incompetency of our Trudeau-led federal government. The assets they picked up from the old Kinder Morgan Canada were quite good. Enbridge and TransCanada should also do well – the big loser going ahead will probably be the oil-by-rail trade – if production slows down, this volume will be the first to get scrapped, not the pipelines.

Trans-Mountain Pipeline / Enbridge / TransCanada

Nobody is laughing out louder today than the management of Kinder Morgan (NYSE: KMI) who have sold their $5 billion pipeline (TSX: KML) to the government of Canada, when a federal court effectively ruled the trans-mountain expansion project to a halt (the reasons of which are not too relevant to the analysis in this post).

(Update, August 31, 2018: See Kinder Morgan’s “laughing to the bank” announcement here)

I’m ignoring the fact that the original Trans-Mountain pipeline still exists and still operates and pumps oil down to the old Chevron Burnaby refinery now owned by Parkland Fuels (TSX: PKI). There is enough pipeline capacity to supply the refinery, but not enough for any meaningful export quantities. This doesn’t make it a complete disaster for Canada, but they sure paid a lot more for it what it is worth.

There are two big economic winners with this court ruling, and it is not Kinder Morgan (they had their victory back in May when the Government of Canada agreed to the sale).

It is Enbridge (TSX: ENB) and TransCanada (TSX: TRP).

The only way to get meaningful amounts of oil out of Alberta and Saskatchewan (other than by much more expensive rail) is now going through the Enbridge Line 3 project or the TransCanada Keystone Pipeline.

(Here’s a map of oil and gas pipelines in Canada)

The economic losers are the Government of Canada, and every major oil producer in Alberta or Saskatchewan: they still have to go through Enbridge or TransCanada pipelines and pay a very heavy differential to prevailing energy prices for a long, long time. Inevitably this will hurt the Canadian public as the purchasing power of their currency will be less than what it could be had we actually have a fully functioning economy, but these indirect effects are typically never measured nor felt as the absence of an effect is rarely lamented in the minds of most people.

Politically, there is one big winner: The BC Government. Premier John Horgan has a huge victory to show to the environmental activist wing of his political party (the BC NDP) and this will give him more clearance to operate in the province without internal opposition (which is historically how the BC NDP loses power).

I am somewhat surprised Enbridge and TransCanada are not doing better in trading today.