This year’s MLPA conference at the Hyatt Regency Orlando reflected the sector’s current transition. It was rebranded from years past to be the MLP & Energy Infrastructure Conference (MEIC), now open to energy infrastructure corporations as well as MLPs. Revealingly, this inevitable recognition of the continuing shift of MLPs to a corporate structure was not embraced by former MLPs. Kinder Morgan (KMI), Oneok Inc (OKE) and Williams Companies (WMB) all declined to participate.

Since almost no corporations showed up, it was an MLP conference after all, albeit with fewer companies and what seemed like a smaller crowd. The conference took place in a more modest set of ballrooms at the Hyatt while another, unrelated event occupied the larger space. The managers of MLP-dedicated, tax-burdened funds (see AMLP’s Tax Bondage) are alone in their unequivocal support of MLPs as the best way to invest in energy infrastructure. The diminished conference must have been a sobering assault on their conviction.

Clearly, energy infrastructure corporations see no value in being associated with MLPs. Moreover, in the smaller group meetings of a half dozen or so investors with management teams, most MLPs were left defending their decision to persist with the MLP structure. “When will you convert to a corporation?”, known as the Simplification Question, came up in every single meeting we attended, even when the company was doing very well (such as Crestwood, CEQP). One management team had an internal over/under bet on how many times they’d be asked all day – trading was at 75.

The industry’s shift to a growth model has already alienated their traditional, income seeking investor base by resulting in widespread distribution cuts to pay for new projects (see Will MLP Distribution Cuts Pay Off?). This is a self-inflicted wound, but the March FERC (Federal Energy Regulatory Commission) Policy Statement may turn out to be nearly as ruinous (see FERC Ruling Pushes Pipelines Out of MLPs). A panel of lawyers discussed the thinking behind the change, which was cited by both WMB and Enbridge (ENB) last week as they rolled up their MLPs into the corporate parent (see Transco Dumps its MLP). Attendees overflowed from the cozy ballroom.

It seems highly likely that FERC  gave only brief consideration to the impact of disallowing income tax expense from cost-of-service natural gas pipeline contracts. The idea that an MLP could expense taxes paid by its equity holders in calculating rates strikes some as odd, but it had been accepted practice for many years. Following a successful court challenge in 2016, FERC waited almost two years to implement the regulatory change required by the judge’s ruling. FERC’s ponderous approach, as well as subsequent questions over precise implementation details, provided further impetus to abandon the uncertainty of the MLP structure. Corporate-owned pipelines are not similarly affected, and so represent a more predictable form of ownership.

One odd twist is that although disallowing an expense ought to benefit the customer, by rolling up into a corporate parent an MLP’s assets are revalued from historic cost to market values. This could ultimately lead to higher tariffs, since cost of service must include an appropriate return on a now more highly valued asset. The lawyers on the panel were unwilling to criticize FERC, since they often represent clients appealing the regulator’s decisions. Among attendees, there was widespread consensus that FERC had screwed up. However, the panel held out little hope of a policy change unless ordered by a Federal court.

Meetings with management teams weren’t only about changing structure. Fundamentals are very strong across the U.S. energy industry, and business is booming for midstream infrastructure. Pursuit of growth projects, while maintaining healthy distribution coverage and reducing leverage, was the theme. The Shale Revolution has long been a volume success, but it’s finally translating into a financial success as well. Investors have had a long wait.

Although the Permian is producing record amounts of crude oil, one CEO said he thought associated natural gas output could reach 30 Billion Cubic Feet per Day (BCF/D), versus 8-9 BCF/D currently. He felt inadequate take-away infrastructure would consequently drive the price at the local Waha hub to $1 per Million Cubic Feet. American natural gas is likely to remain among the world’s cheapest.

Water disposal came up in some discussions, and with volumes of produced water (i.e. water that comes out of the ground with the oil) in the Permian running at 4X the amount of crude output, treatment and disposal is providing additional infrastructure opportunities. Several firms were considering investments in this area.

Plains All American (PAGP/PAA) management was surprisingly defensive when asked about their simplification plans. They feigned surprise at the question (perhaps out of boredom) and suggested to one investor that perhaps he didn’t fully understand their structure. What’s really hard to understand is how the biggest crude oil pipeline operator in the Permian isn’t generating better results when record oil production is exceeding take-away pipeline capacity.

This has caused the Midland-Cushing differential to widen to $15 per barrel recently, far above the $2-3 pipeline tariff between the two hubs (see Dwindling Pipeline Capacity Causes FOMO). It should be a huge win for PAGP, whose investors holds the stock for precisely this scenario. But earlier 2016-17 mis-steps in Supply and Logistics caused PAGP to hedge 2018 basis risk far more conservatively, largely missing out on today’s excess demand for pipeline capacity. At still approximately 60% below their 2013 IPO price, PAGP’s stock reflects the need for better execution by management.

CEQP continues to execute well and met with many happy investors given the stock’s climb over the past couple of years. Meetings with Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP) were typically reassuring. Neither sees the need to convert from their MLP structure.

Enlink (ENLC/ENLK) Chairman Barry Davis described how they were emulating parent company Devon Energy’s (DVN) investment in IT to manage their operations. DVN has a single Data Control Center that remotely monitors all their activities. ENLC has created a task force to find similar opportunities to automate.

“Refracs” (when today’s new technology is applied to a previously fracked well) are delivering some impressive results for DVN in the Barnett shale for around $600K per well. But as in the past, ENLC will benefit as DVN sheds those assets in a region that they don’t deem strategic, to others willing to invest the time and capital. Nonetheless, a play believed to be in decline continues to maintain flat production.

Cheniere (LNG) explained how, in signing up customers for their next export facility, they can guarantee capacity from Sabine Pass as a stop-gap. Producers are sometimes unwilling to make a binding commitment to use new infrastructure when they’re unsure it’ll get built. LNG’s early-mover advantage allows them to guarantee capacity on Train 3 to producers who sign up for yet-to-be-built Train 6, which makes it easier to get customer commitments.

The industry’s fundamentals are good but complaints were heard that questions of structure continue to dominate. Many feel the MLP-only indices are losing relevance, and unanswered questions linger over the future of MLP-dedicated funds such as the Alerian MLP ETF (AMLP) and many mutual funds, since they face a shrinking number of MLPs to hold (see The Alerian Problem).

Next year REITs will apparently be added to the conference, which is relocating to Las Vegas. The conference organizers grasp the need for a broader approach.

We are long CEQP, ENB, ENLC, KMI, LNG, PAGP and WMB. We are short AMLP.

On the University of Texas website is a documentary titled Gift from the Earth: Natural Gas. It describes the construction of a pipeline to transport natural gas from Texas to population centers on the east coast, as far away as New York City. The pipeline was built by the Transcontinental Gas Company (Transco), and the documentary is from the 1950s.

Today, Transco has grown into America’s largest natural gas pipeline network. Since 1995 it’s been owned by Williams Partners (WPZ). With some justification, WPZ management describes it as irreplaceable – the cost to acquire the land and easement rights combined with the infrastructure itself would run into the tens of $Billions. WPZ is 6.6% of the Alerian MLP Index (AMZ) and 8.1% of the Alerian MLP Infrastructure Index (AMZI). It will soon be leaving.

Williams Companies (WMB) is WPZ’s corporate parent. They concluded that the advantages of having an MLP had diminished, and that their business will grow faster by rolling up the remaining publicly held units of WPZ (WMB already owns 74%) into the parent. Oneok Inc. (OKE), which absorbed its MLP last year, has an Enterprise Value/EBITDA multiple of 15-16X, a valuation WMB must feel is attainable from its present 11-12X.

MLPs retained their tax-free status through last year’s tax reform. The problem is that the investor base remains frustratingly narrow. Those who face tax hurdles in buying MLPs include tax-exempt U.S. institutions and non-U.S. buyers, together a substantial percentage of U.S. equity holders. Most individuals are put off by the K-1s rather than 1099s for tax reporting. That leaves older, wealthy Americans whose accountants prepare their tax returns as the main source of equity capital.

Given their dependence on a fairly limited set of buyers, you might think MLPs would have treated them better. These holders were attracted by high, reliable tax-deferred payouts combined with modest growth. The Shale Revolution created new business opportunities that raised leverage, leading to slashed distributions (over 50 so far), and simplifications that come with a tax bill. Betrayed, these older, wealthy Americans now regard with skepticism MLP yields that are historically high, thereby raising the cost of equity capital for the sector.

Having destroyed their original buyers’ appetite, many companies have concluded that they need access to all the global equity investors, which requires being a corporation. On the same day that WMB announced their roll-up transaction, Enbridge Inc (ENB) made a similar move with their four sponsored vehicles, including MLPs Spectra Energy Partners (SEP) and Enbridge Energy Partners (EEP).

Uncertainty over FERC policy (see FERC Ruling Pushes Pipelines Out of MLPs) has also weighed on the sector, prompting some considering incorporation to move ahead.  WMB and ENB are the most recent in a steady stream of companies abandoning the MLP structure. In the past couple of months three other MLPs have made similar announcements, representing in aggregate 13.3% of AMZ (benchmark for numerous funds) and 15.5% of AMZI (benchmark for the Alerian MLP ETF, AMLP) which, absent further changes, will drop from 26 constituents today to 21.

This need not matter for direct holders. If your MLP is absorbed by its corporate parent, your MLP units are swapped for corporate equity securities. The assets are still there. In a now familiar routine, as they part with their WPZ units, WPZ holders will receive a tax bill for deferred income tax as well as a dividend cut (since WMB’s $1.36 dividend multiplied by the 1.494 exchange ratio is $2.03, 17% lower than WPZ’s current $2.46 distribution). It’s WPZ’s third cut in the last four years, so they must be getting used to it. Meanwhile, WMB will create a tax shield for itself through a stepped up cost basis on the acquired WPZ assets, making it 2024 before they’ll be a cash tax payer. This common benefit first drew attention when used four years ago (see The Tax Story Behind Kinder Morgan’s Big Transaction).

The new WMB will finance its growth with asset sales and reinvested profits while reducing leverage. They expect 10-15% annual dividend growth. It’s generally all good for WMB investors. But for many, the bigger story continues to be the impact of a steadily shrinking MLP universe on MLP-dedicated mutual funds and ETFs. AMLP and many MLP mutual funds now combine a tax-burdened corporate structure (see AMLP’s Tax Bondage) with a shrinking opportunity set that will soon exclude America’s biggest natural gas pipeline network. The problem has been growing (see Are MLPs Going Away? and The Alerian Problem).

In an amusing twist, during WMB’s investor day one analyst asked whether they’d considered maintaining Transco’s ownership within an MLP by shifting it into a blocker corporation. This is similar to the structure used by tax-burdened funds such as AMLP. WMB CEO Alan Armstrong replied that the additional corporate tax liability rendered such a solution uneconomic through multiple layers of taxation. In other words, the structure by which AMLP holds WPZ is regarded as unworkable when considered by parent WMB.

The promoters of such poorly structured funds deny a problem, which leaves it to their investors to do their own homework. Fewer MLPs may even cause investors to exit such funds in search of more diversified exposure, depressing prices. ENB’s press release referred to, “…the continuing deterioration in the MLP equity marketplace.”  Their presentation asserts that, “Sponsored vehicles are ineffective and unreliable standalone financing vehicles.” MLPs aren’t going away, but they’re clearly not an attractive choice for companies in need of equity capital to grow.

The problem is one of structure, not fundamentals. U.S. hydrocarbon output is hitting new records, in some cases leaving the infrastructure struggling to keep up (see Dwindling Pipeline Capacity Causes FOMO). The appeal of broad-based, tax-efficient energy infrastructure using mostly corporations is strong.

We are invested in ENB, KMI and WMB. We are short AMLP

Reports on the Shale Revolution rarely discuss its impact on U.S. energy security, but with little fanfare it’s affording the U.S. greater geopolitical flexibility. The Administration’s decision last week to withdraw from the Iran nuclear deal was made without significant regard to the ensuing reduction in Iranian oil exports. Successive U.S. presidents back to Richard Nixon have called for U.S. energy independence without being able to achieve it. The U.S. is already energy independent on a BTU-equivalent basis (i.e. we produce more energy than we consume in aggregate). We became natural gas independent last year as Liquefied Natural Gas (LNG) exports ramped up. We’ve been a net exporter of ethane since 2014, and of propane since 2011.

But when a President calls for energy independence – or even energy dominance – he means crude oil. Here, the story is almost as good. In August 2006, net imports of crude oil and petroleum products hit 13.4 Million Barrels per Day (MMB/D). Today that figure is below 3 MMB/D. Even when the U.S. does become a net exporter we’ll still be importing the sour, heavy crude favored by domestic refineries while exporting the lighter grades that are increasingly produced from shale.

Furthermore, our imports are increasingly from friendly countries. Canadian exports to the U.S. have been rising for years and are currently 4.3MMB/D, while OPEC imports have dropped by 50% in the past decade, to below 3 MMB/D. U.S. imports from Iran ceased entirely during the 1980 hostage crisis and have never recovered. In fact, total trade in goods between the U.S. and Iran was an inconsequential $200MM last year. While Iran is of no economic value to the U.S., the likely imposition of sanctions will constrain Iran’s exports to other countries. The recent rally in crude is in part attributed to fears of less Iranian crude on the global market – they currently produce 3.8MMB/D.

But the U.S. is far less vulnerable to a price spike than in the past. Oil-producing states such as Texas, North Dakota, New Mexico and Oklahoma will welcome the economic boost. Treasury secretary Steve Mnuchin was reported to have discussed with U.S. oil companies ways in which they could raise output, but any decisions are likely to be commercially driven. The Federal government was of little help to the industry during the 2014-16 oil price collapse, and has limited near term ability to influence production levels.

U.S. crude output is responding. Rising prices and falling break-evens are improving profitability, driving output to 10.7MMB/D. Just a year ago, the U.S. Energy Information Agency (EIA) was forecasting 2018 output of 9.9MMB/D, likely 1 MMB/D too low. They now expect 2019 to average 11.9MMB/D. Although growing strongly, U.S. output is insufficient to meet new global demand (~1.5MMB/D) plus offset depletion of existing oil fields (estimated 3-4 MMB/D). OPEC is showing surprising discipline in sticking to their supply agreement. Iran’s exports will likely drop and Venezuela’s production is in freefall. It’s not hard to make a bullish case for oil, and for U.S. companies involved in its production and transportation.

Infrastructure constraints are appearing (see Dwindling Pipeline Capacity Causes FOMO), most visibly in the Midland-Houston crude spread which recently exceeded $15. Wellhead prices can suffer an additional discount of up to $8/bbl to adjust for trucking and shuttle pipeline transportation costs to Midland.  Differentials are far in excess of the cost of pipeline transport, because pipelines leaving the Permian in west Texas are full. There are reports that the rail network is clogged with trainloads of fracking sand entering the region, while trucks and truckers are in short supply. Although the logistical challenges offer profit opportunities for the owners of energy infrastructure, in the near term crude output growth may be constrained.

It’s even more acute for Permian natural gas production, which is an associated by-product of crude oil output. On Energy Transfer’s earnings call COO Marshall McCrea predicted occasional days of no bid for natural gas at the Waha hub, a collection point for Permian gas. That’ll leave drillers contemplating flaring of natural gas or shutting in otherwise profitable wells while the infrastructure catches up.

In March, before today’s pipeline constraints had affected price differentials, Magellan Midstream Partners (MMP) dropped plans to add a pipeline that would have moved 350,000 Barrels per Day of crude across Texas, because not enough producers would guarantee to use it. Pioneer Natural Resources (PXD) CEO Scott Sheffield warned the industry, ““Oil has a problem late this year and also in 2020.” He added, “It will teach these producers a lesson that they better sign up.”

In other words, insufficient pipeline capacity is in part down to the earlier reluctance of producers to commit, which discouraged the development of infrastructure that would have been in use today. Smaller firms, often privately owned, are more vulnerable than large ones. PXD has firm transportation contracts in place for their increasing production of oil and gas, a point they highlighted in their recent earnings presentation.

One analyst at Rystad Energy blamed energy infrastructure companies for the bottlenecks, saying they had, “…really missed their opportunity when there was a need for investment in new capacity.” In fact, the multi-year travails of MLPs can be traced to the relentless pursuit of growth projects by management teams at the expense of stable distributions (see Will MLP Distributions Pay Off?). When capital was available and customer commitments forthcoming, new infrastructure was built. Oil producers have surprised many, including themselves, at the volume growth efficiencies have made possible. PXD reports Permian breakevens for producers at under $30 per barrel, and in their 1Q18 earnings report show their own costs at around $19 per barrel.

Thanks to the Shale Revolution, U.S. geopolitical decisions are benefiting from more strategic flexibility than in the past.

We are invested in Energy Transfer Equity (ETE), General Partner of ETP, and MMP

Last week was a busy week of earnings reports for many sectors, including energy infrastructure. Growing energy sector profitability is feeding through to higher returns to investors. Over the past month the S&P Energy Sector ETF (XLE) has outperformed the S&P by over 9%. RBN Energy has a good blog post (see Better – E&P Profits Appear Ready To Take Off This Year After Turning A Corner In 2017), highlighting that the 2017 impairments are unlikely to be repeated and that higher oil prices will drive improved operating margins.

Enterprise Products Partners (EPD) reported 1Q18 EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of almost $1.7BN, 11.5% ahead of consensus. That was a significant beat for such a large, stable business as every segment did better than expected. EPD has a premier position on the Gulf Coast and is a leading exporter of U.S petroleum liquids.  On the call, CEO Jim Teague highlighted the value of midstream companies in getting product to the global market. “The name of the game for U.S. production is exports, exports, exports, exports, of crude oil, natural gas, ethane, LPG, petrochemicals and refined products.”  Last year EPD trimmed its forecast distribution growth in order to redirect more cashflows into growth projects. Income seeking investors were underwhelmed, but it simply reflected EPD’s response to the changing MLP business model.

1Q18 earnings reported by Oneok (OKE) beat expectations by 4%, driven by strength in their Natural Gas Liquids segment in the SCOOP and STACK play in Oklahoma. Pembina (PPL) announced a 19% year-on-year dividend increase as their Veresen acquisition and assets recently placed into service powered EBITDA growth. Targa Resources (TRGP) reported a solid quarter and positive outlook.  They are the leader in providing gathering and processing in the Permian Basin, but even more interesting was the volume growth they saw elsewhere, in North Dakota and South Texas. Tallgrass Energy Partners (TEP) reported on their earnings call increasing throughput on their Pony Express crude pipeline that links the Bakken in North Dakota to Cushing, OK. 1Q18 volumes averaged 290 thousand barrels per day (MB/D), up by 22MB/D on 4Q17, and are expected to reach 350MB/D this month. This shows that it’s not just Permian crude output that is growing, with U.S. production reaching 10.6MMB/D. Record earnings and volumes were reported by a good number of names.

Most dramatically, Cheniere Energy (LNG) announced consolidated EBITDA of $907MM, up 88% on a year ago and 46% ahead of expectations. They raised full year guidance by 14%. Surging demand for U.S. exports of Liquified Natural Gas underpin the outlook. Higher crude prices are also improving the competitive position of U.S. exports since global natural gas pricing is often linked to crude oil while U.S. domestic gas prices remain among the lowest in the world.

Energy infrastructure businesses do better when their customers are thriving. Growing oil and gas production is creating tightness in some of the support functions. We recently highlighted the Midland-Houston spread for crude oil, which should normally be limited by the $2-3 pipeline tariff to move crude from the Permian wellhead to customers on the Gulf Coast (see Dwindling Pipeline Capacity Causes FOMO). Limited pipeline capacity had caused the differential to increase to over $6, as producers were forced to utilize more expensive rail or truck transportation. Last week the spread reached $12, beyond the cost of rail transportation and therefore indicating greater use of trucks.

The losers are oil producers without contracted pipeline take-away capacity. The pipeline industry often complains about “freeloaders”; pipelines are built once enough capacity has been contracted out to meet required return thresholds. Oil and gas producers who don’t make those early commitments can still access the pipeline once it’s built. They benefit from the support of their peers who underwrote the infrastructure development. But when pipeline capacity is tight, these “walk-up” customers have to pay market rates, which rise. Plains All American (PAA) will announce earnings on Tuesday, and as the biggest crude oil pipeline operator in the Permian, their comments on demand for takeaway capacity will be especially interesting.

Not everything was good. Marathon Petroleum (MPC) acquired Andeavor, orphaning MLP Andeavor Logistics (ANDX). We highlighted in last week’s blog that corporate parent TransCanada (TRP) had said their MLP, TC Pipelines (TCP), was no longer viable as a funding vehicle, rendering them of little use to TRP. Subsequently, TCP slashed their distribution by 35%. The recent FERC ruling was the cause. Spectra Energy (SEP) and Enbridge Energy Partners (EEP) were similarly weak as investors contemplated their “orphan” status. One subscriber asked us if he should avoid MLPs entirely that have a separate General Partner (GP), given recent developments. As regular readers know, we only hold MLPs that have no GP, to avoid just the sort of issue faced by TCP investors.

Williams Companies (WMB) set new volume records for gas on its TransCo system, but offered little new regarding a potential combination with their MLP Williams Partners (WPZ). Their Analyst Day later this month is expected to offer an update. WPZ investors face the risk that a combination with WMB will trigger a tax bill for deferred income.

Broad energy infrastructure as defined by the American Energy Independence Index continues to outperform the narrower Alerian MLP Index (AMZ), a trend set in motion by the FERC ruling in March. AMZ remains below its pre-FERC announcement level. Although MLPs retain an important tax advantage over corporate ownership of energy infrastructure assets, the several dozen distribution cuts by MLPs since 2014, as well as unwelcome simplification transactions, have clearly soured their traditional investor base. MLPs are evolving towards more internally-financed growth, which is for now impeding distribution growth.

On Tuesday, we’ll be ringing the NYSE closing bell to celebrate the recent launch of our ETF. Check us out on CNBC at 4pm.

We are invested in EPD, LNG, MPC, OKE, PPL, TRGP, TEGP (GP of TEP) and WMB