Last Monday, June 22nd, Energy Transfer Equity (ETE) went public with their rejected merger proposal to Williams Companies (WMB) in an effort to force WMB to the negotiating table. WMB’s stock rose by most of the 32% premium ETE has offered, and in recent days has held on to most of that gain as the market has assessed likely outcomes. ETE’s presentation highlights the synergies of such a combination. Another comforting fact is the ownership of WMB stock by hedge funds Corvex and Soroban, who hold 5.6% and 2.8% respectively. Corvex has not always been a positive influence for stockholders, and last year we wrote about the “Corvex Discount” that should apply to any stock they own (see Williams Companies Has a Corvex Discount). However, in spite of this we are long-time investors in WMB. It’s worth noting that Corvex and Soroban are on WMB’s board, so their views will be a factor in any decision.

The headlines will focus on developments at WMB as they consider their strategic options in light of ETE’s interest in them. We think WMB is likely to move higher as a result. What’s drawn less attention is the likely outcome for Williams Partners (WPZ), the MLP that WMB controls as its GP. On May 13th, WMB announced plans to acquire the outstanding units of WPZ, in a transaction intended to boost WMB’s dividend growth in part through tax gains from depreciating the newly acquired assets from a higher valuation. It’s the same technique used by Kinder Morgan last year to fuel faster distribution growth at KMI when they announced plans to combine Kinder Morgan Partners, El Paso and Kinder Morgan Management into one entity (see The Tax Story Behind Kinder Morgan’s Big Transaction). The tax insight KMI had was that acquiring assets from a limited partnership allows them to be revalued at the purchase price, and thereafter depreciated against taxes from this higher level. The practical consequences were $20 billion in tax savings for KMI which helped fuel a doubling of their forecast dividend growth to 10%, and an unexpected tax bill for Kinder Morgan Partners unitholders since the transaction resulted in a sale of their LP units not necessarily at a time of their choosing.

WMB’s previously announced plan to acquire outstanding WPZ units is also driven in part by this favorable tax treatment. However, ETE’s merger proposal is conditional on WMB dropping its announced plans to buy WPZ. ETE doesn’t want that transaction to go through. As a result, although WMB’s stock rose substantially following the announcement, the price of WPZ units fell.

To understand why, you have to regard MLPs as hedge funds and MLP GPs as hedge fund managers, a view we’ve long articulated and one evidently shared with the senior managers of many MLPs (see Follow the MLP Money). If you want to control the assets of a hedge fund, you do that by controlling the hedge fund manager, not by investing in the hedge fund. Similarly, Kelcy Warren (ETE’s CEO) understands that to control the assets owned by WPZ he need only control WMB’s GP, not WPZ itself. Under this analysis, paying a premium to acquire WPZ units may not be the best use of capital, and in fact leaving WPZ as a publicly traded MLP (albeit with two thirds of its LP units owned by WMB) provides optionality. If WPZ’s cost of capital falls, ETE may drop assets into it where they can be cheaply financed. Or, if WPZ’s yield remains high they may retire some LP units. Having WPZ remain out there is, in ETE’s view, a good thing. It shows that the decisions get made by the owners of the MLP GPs, not the MLP unitholders themselves. As we’ve said before, the MLP GP is like a hedge fund manager.

A question I’m often asked is how the business prospects of many MLPs will respond permanently to lower prices for oil and gas, perhaps lower than where they are today.

From a high level, markets often appear vulnerable to a correction. This is especially true with the S&P500. You rarely hear anyone simply say the market looks cheap, and in fact it’s easy to find reasons to worry. Today it’s rising rates and the threat of Grexit, but there’s always something to worry about. And if there isn’t, then you can worry about complacency. For me, the solution is to look at individual companies, because while the market outlook can be uncertain, the prospects for (fill in the blank) corporation often appear far more tangible and clear than for the broader averages.

The same is true with MLPs. Prices have fallen along with the energy sector. So look at Cheniere Energy and their LNG export facilities at Sabine Pass, LA and Corpus Christie, TX. It may seem quaint to remember, but not that many years ago the U.S. was preparing to import LNG. The two abovementioned facilities were built for that reason, until the boom in domestic natural gas production led to a glut and rendered the economic assumptions underlying imports no longer valid.

So the facilities were switched to export LNG instead. This is not a trivial task. Natural gas has to be compressed and cooled to around -256 degrees Fahrenheit before being piped into the large spherical tanks you see on LNG tankers. Handling LNG is far harder than crude oil, and the regulatory oversight is substantial as you might imagine. An accident at an LNG terminal would be a spectacular sight as long as viewed from many miles away.

Cheniere’s CEO Charif Souki has a substantially bigger risk appetite than ours, as I’ve written before (see U.S. Natural Gas Terms of Trade Continue to Shift) but he is close to starting operations at the first LNG export facility in the lower 48 states. The relevance to MLPs of this milestone is that the natural gas that Cheniere will export has to be transported to their terminals via pipeline and stored prior to processing and loading onto LNG tankers. Two important infrastructure providers are Kinder Morgan (KMI) and Williams Companies (WMB). KMI announced plans to provide pipeline capacity and storage for Cheniere’s Corpus Christie facility back in December.

WMB will be expanding its Transco pipeline network, an enormous connection of pipelines and supporting infrastructure running down the eastern U.S. from the north east to Texas. Last year they announced they’d be building Gulf Trace which will bring natural gas from the Marcellus Shale in Pennsylvania down to the Sabine Pass LNG export terminal and from there to foreign customers.

The question of whether low commodity prices are good for energy infrastructure is not one that can be answered with a simple “yes” or “no”. The LNG export projects provide an example of how the domestic energy business is exploiting opportunities from low domestic prices.

We are invested in KMI and WMB.

People often ask me how I think equity markets, including Master Limited Partnerships (MLPs), will perform when interest rates are rising. It’s a timely question, since bond yields have been moving higher for the past couple of months. The yield on the ten year U.S. treasury recently touched 2.5% as markets look ahead to a tightening by the Fed later this year. Of course, the Fed has been steadily pushing back the first rate hike, since it turns out they’re not any better at forecasting rates than the private sector, as I wrote a couple of months ago in Preparing for Higher Rates. Nonetheless, they will be right eventually and financial advisors would like to be prepared.

The relationship between interest rates and most asset classes is not simple. Bond prices mathematically fall with rising yields since their payouts are fixed, but equity securities whose return comes from both dividends and dividend growth have a more complicated relationship with rates.

Stronger economic activity can be expected to translate into faster profit growth and higher dividends, in which case higher rates represent confirmation of a more robust economy and need not be negative. Conversely, if rates rise while inflation is unchanged, it results in higher real rates (i.e. after inflation) and this in theory reduces the value of all assets.

But we know rates will rise, and the yield curve is pricing in the expectation of a higher Fed Funds rate in the next 6-12 months. So part of the question comes down to what the market will do if the market’s own forecast of the timing of rising rates turns out to be correct. In this respect, it boils down to a question of market psychology; if rates rise following the path already reflected in the yield curve, it ought not to surprise. In fact, the prices of treasury bonds ought not to change, in theory, since their prices already reflect that path. They obviously will move, but where will they, and equity markets, settle?

I have a friend who has an exceptionally acute sense of such things. Through seemingly logical analysis, he often arrives at an insight that sometimes seems so obvious but wasn’t at all clear until he pointed it out. On this topic, he recently noted to me that if he was considering buying stocks but planned to sell upon a Fed rate hike later this year, he wouldn’t invest. It seems so blindingly obvious, but if something unsurprising will happen that would cause you to sell, you would avoid putting yourself in that position.

Therefore, if you put yourself in the mind of this mythical yet rational investor; if this participant isn’t going to sell stocks at that time, who is? And the answer is, people with a short term horizon who expect selling by others and wish to avoid a near-term drop in their portfolios, or hope to buy back shortly afterwards. And from whom exactly will they buy back their shares, if our mythical yet rational investor (perhaps with many like-minded folk) is not then a seller?

This is exactly the kind of set-up that can cause equity markets to reach higher prices than existed prior to the “news”, as the participants expecting to buy from other more hasty investors find far fewer such impulsive folk exist than they might have expected. We don’t forecast equity markets, but don’t be shocked if stocks rally on the first rate hike.

The analysis of market psychology is of course an endless game that never ends. Events big and small are anticipated, happen and are reacted to along with big and small surprises too. As soon as the aftermath of one event reveals the true disposition of willing buyers and sellers through their subsequent actions, the build-up to another event begins. It’s very hard to be good at figuring this out, and in my experience the supply of people with opinions far and away exceeds the number whose views result in profitable outcomes. But I know just a very few who have turned astute observation into market profitability.

For our part, while this type of prognostication can be fascinating, there isn’t a plausible move in interest rates that would cause us to sell investments which are, by definition, held for the long run. Several months at least lie between today and the resolution of that particular event. When it happens, if equity markets fall, we shall be among those whose portfolios suffer a loss in value. However, we shall not be a seller in response to something not surprising. Ben Graham is believed to have said that in the short run the market is a voting machine while in the long run it’s a weighing machine. We’ll weigh things up down the road.

Plains All American Pipeline (PAA) held their Investor Day on Thursday. The presentations included a fascinating analysis of the global oil market with a view to forecasting prices as well as regional supply/demand, since these are important drivers of PAA’s planned infrastructure development. The chart at the left, reproduced from PAA’s Investor Day deck, plainly shows the impact of growing North American output on the global market. Since 2011 global supply has increased by a little over 4 MMB/D, 1.4MMB/D in excess of demand growth which is why inventories have grown. Moreover, North America has met more than 100% of this increase in global demand, since output in the rest of the world has net fallen somewhat. This simple graphic illustrates as well as anything that the Shale Revolution in the U.S. has not just been a North American story but has impacted the global oil market, most obviously through the drop in prices since last Summer.

A corollary to this is that growing U.S. production is reducing import demand, as U.S. refiners process more domestic crude oil. However, U.S. refineries are generally better able to process the heavy crude that we’ve historically imported, and the light sweet crude that is typically produced from domestic fields is not as good a fit for many refining facilities. There are also distribution bottlenecks which are gradually being alleviated, but in combination these two factors along with the ban on crude oil exports account for the discount of WTI crude compared with Brent.

The export ban dates back to the 1970s, and looks increasingly anachronistic today. You might expect the oil industry (excluding refiners who benefit from captive suppliers) to favor repealing the export ban. Greg Armstrong, PAA’s CEO, acknowledged the free market argument in favor of doing so but also conceded limited political support for such a move. It would seem intuitive that allowing domestic oil to be sold overseas would raise its price and therefore increase the cost of domestic refined products, including gasoline, which explains the limited political support.

Surprisingly though, quite a number of independent studies have concluded that allowing U.S. exports of crude oil would lower domestic gasoline prices. The analysis predicts that selling U.S. oil on the world market would increase global supply and further stimulate domestic production, thereby lowering gas prices. It’s not obvious; unsurprisingly,  the American Petroleum Institute makes the case but among the many sources they cite are included the Federal Reserve Bank of Dallas and the Congressional Budget Office, two entities not that connected to E&P. So although political support isn’t strong today, the economic case is more supportive than you might first think. Lifting the ban would be good for the domestic energy industry including infrastructure.

On a different topic, Greece is once again in the news as another critical deadline approaches. It may not be much appreciated or even known by their creditors, who are now largely the IMF and the ECB, but as I wrote in Bonds Are Not Forever, since gaining independence from Turkey in 1822 Greece has been in default approximately 50% of the time. Given this checkered history as a reliable debtor, the repayment expectations of Greece’s creditors are barely credible. Under the capital guidelines on developed country debt in force prior to the 2008 financial crisis, Greece’s debt drew the same capital requirements as Germany’s for those banks which held it (which were numerous), in willful defiance of history as well as common sense. Much of that debt is now held by their current creditors, having been transferred from private hands to public in a prior renegotiation. But it seems to me that if it’s stupid to borrow what you can’t repay, it’s stupider to lend what probably can’t be repaid. Greece is an example of the general abundance of debt in the financial system. While not every borrower is Greece, today’s bond investors are offered an unlimited supply to choose from, yet at yields that would suggest scarcity. The thoughtful bond investor is switching asset classes.

We are invested in Plains GP Holdings, the General Partner of PAA.