New York and much of the northeast US was shrouded in smoke from Canadian wildfires last week. Westfield, NJ is around 21 miles from lower Manhattan, which is normally visible if you’re at a high enough point. Last Wednesday it was not. Neither was the sun. Millions of Americans experienced air quality more usually associated with New Delhi.

Global warming gets blamed for most unusual weather events. Whenever it’s exceptionally wet/dry/cold/hot/windy it’s because humans are increasing CO2 levels. Regular readers know we are in favor of strategies to lower CO2. Substituting natural gas for coal is a practical solution already responsible for US success in reducing emissions. More nuclear power seems obvious. We’re not excited at the prospect of increased reliance on weather-dependent solar and wind.

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The New York Times duly reported that, “Human-caused climate change is a force behind extremes like these.” It fits the narrative. Except the data doesn’t support it. Over the past four decades the number of fires in Canada has been declining, and the worst years were in the 80s and 90s in terms of area burned. That’s not to say that lowering CO2 emissions isn’t good if pursued without impoverishing us all. Just that the smoke hanging over North America’s population centers isn’t evidence of a CO2 problem.

The world is beginning to tire of the shrill climate extremists intent on imposing economic devastation and austerity on the rest of us. In the UK the Just Stop Oil people have enjoyed extraordinary freedom to disrupt everyone else. Groups of them standing in the road blocking traffic are protected by police. There are several videos of irate drivers being arrested for trying to push the protesters out of the way.

The list of what makes America great is long. The absence of an American version of these protesters is somewhere in the middle of the list. They would be run over or perhaps even shot at. UK public opinion is asking why the wrong people are being arrested. Sometimes it looks like Little Britain.

In Germany, the Greens have long held outsized influence over policy because of their swing vote in the coalitions that typically form government. “Green getting too Brown” is a more severe criticism than it looks, referencing the brown shirts of the Nazi party. “Heizhammer” (heating hammer) is how many refer to plans pushed by the Greens to accelerate the adoption of expensive, energy efficient heat pumps.

Germany is a global leader in spending money on the energy transition, if not in results. Last year their CO2 emissions were unchanged because they increased coal use to replace Russian natural gas. This was in spite of a 4.7% drop in energy consumption, as industry responded to high prices by curtailing production and in some cases relocating to other countries, including America. Germany’s electricity prices are among the world’s highest. There’s little in their energy policies that others should wish to emulate.

German public opinion is shifting. The Greens now rank behind the far right AfD in polls.

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US energy policies at the Federal level rely more on tax credits and other financial incentives. A few liberal states such as New York are making it harder to access reliable energy, by for example banning natural gas hookups to new buildings.

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Nonetheless, domestic production continues to grow. Last year the Permian region in west Texas and New Mexico hit another record at 21 Billion Cubic Feet per Day (BCF/D). It’s second only to the Marcellus/Utica region (collectively Appalachia). The Energy Information Administration (EIA) reported that this past winter power generation from natural gas set a new record at 619 billion kilowatthours. Renewables are growing but America’s electricity still comes from natural gas.

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The focus on renewables overlooks the fact that electricity is around 23% of global final energy consumption. Within US manufacturing for example, electricity use has remained roughly unchanged at under 15% of energy use for decades. Natural gas use is growing and represents almost 3X electricity.

Because the US hasn’t followed extreme energy policies like Germany, reliable cheap energy is drawing manufacturing here. Germany felt good about their ability to reduce energy consumption last year, but in part it represented production facilities relocating because they were losing competitiveness.

China, consumer of half the world’s coal and the biggest determinant of global CO2 emissions, recently said non-fossil fuel energy sources exceed 50% of their total installed electricity generation capacity. The problem is you can’t believe anything the Chinese government says. So it may or may not be true.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

The Mountain Valley Pipeline (MVP) has suffered countless delays because of continued legal challenges from environmental extremists. Permits issued by Federal agencies were on many occasions rescinded by judges. No infrastructure of any kind can be built with such a process. When the recently passed debt ceiling legislation deemed completing MVP “in the national interest” it implicitly acknowledged that the permitting process is broken. This overrode the prior legal judgments. Let’s hope this provides impetus for reform.

Equitrans (ETRN), whose frustrated efforts to complete MVP led to its extraordinary approval by legislation, has gained over 50% as a result. The stock had previously included no value for MVP, priced as if it would never be completed. NextEra, a partner in MVP, wrote its carrying value down to zero last year.

But ETRN remains well short of fully reflecting MVP’s value. Morgan Stanley has estimated a $14 sum-of-the-parts price target for ETRN. RBC has a Base Case of $10 and an Upside Case of $14. It’s currently at $9.50. The threat of further legal challenges remains. The legislation removed the jurisdiction of any court over actions by Federal agencies on this matter. But it allowed any claim against the law’s validity to be heard by the DC District US Court of Appeals. Analysts believe it’s highly unlikely any further legal challenges can disrupt MVP’s completion.

We think ETRN remains attractively priced.

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Another situation we’ve been following is NextDecade (NEXT), whose planned Rio Grande LNG export project will be located on the northern shore of the Brownsville Ship Channel in Texas, with easy access to the Gulf of Mexico. By combining carbon capture with the condensing of natural gas that’s loaded onto LNG tankers, NEXT says it will be the only such US facility offering CO2 emissions reduction of more than 90 percent.

In April FERC re-approved the construction of Rio Grande. The next step is for NEXT to approve a Final Investment Decision (FID) so that construction can move ahead. CEO Matthew Schatzman expects FID to come before the end of this month.

Substantial uncertainty remains over how it will be financed. We estimate that building three trains with 2.3 Billion Cubic feet per Day (BCF/D) will generate $1.8BN in revenues and around $450MM  in income to NEXT annually beginning by 2028. This is an $11-12BN project for a company whose market cap is below $1BN.

NEXT valuation estimates have a wide range. So any estimate of NEXT depends heavily on the mix of debt, preferred and common equity that’s used for financing. The FID announcement should provide enough detail about how Rio Grande LNG will be financed to provide sufficient cash flow visibility that its perceived risk will fall.

We think at current levels it offers an attractive return potential.

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The proposed combination of Oneok (OKE) and Magellan Midstream has dominated our recent blog posts. We won’t relist our reasons for being opposed as we’ve covered them extensively (see Oneok Does A Deal Nobody Needs).

The market-implied probability of the transaction closing has dropped steadily since it was announced on May 15, because the gap between MMP’s current and proposed price is widening. Jim Murchie of Energy Income Partners recently wrote an open letter to MMP where he voiced criticisms similar to ours in objecting to the deal. Investor mood is turning against. Both companies will need to address the market’s cold response to their work.

In recent conversations with investors, several have expressed surprise that the midstream sector isn’t performing better. Equity market leadership is incredibly narrow (see AI And The Pipeline Sector) so unless you own the half dozen or so stocks benefitting from the AI frenzy it’s hard to keep up.

But fund flows into MLP Products, which is a decent proxy for mutual funds and ETFs in midstream energy infrastructure, have been negative every month this year. Last year’s inflow followed four negative years.

1Q23 earnings were good. Capex remains low, helped by opposition to new projects (hug a climate extremist and drive them to their next protest). Dividends are growing by our estimation 2-4%, and buybacks are retiring 2-3% of the sector’s market cap annually. Together with 6%+ yields, this provides the basis for annual returns of 10% or more.

Clearly there’s no irrational exuberance causing investors to throw money at the pipeline sector. Irrational apathy might be more accurate. But the $837MM of net outflows through the first five months of this year is more than offset by the rate at which companies are buying back stock. There’s also the explicit link to inflation in that many pipeline contracts, representing up to half the sector’s EBITDA according to research from Wells Fargo, reprice using either PPI or CPI.

Eventually these persistently strong fundamentals will cause inflows to resume, as they did last year.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

In February, the transcript of the dialogue between Bing’s chatbot and a NYTimes journalist illustrated a weird, unsettling side of Artificial Intelligence (AI). Kevin Roose, the columnist, mischievously led the chatbot through a series of existential questions about feelings which culminated in advice that Roose was in love with Bing, not his earthly companion. It was amusing, except perhaps for the AI programmers at Microsoft who have likely since dialed down Bing’s sentient scale.

Shortly afterwards I started using ChatGPT. I soon found that it can write a blog post. I shall immodestly claim that they are not as informative as my own, at least for now. But I assume their quality will improve, and I’ll have to do the same or risk being an AI unemployment statistic.

The Alerian MLP ETF is a true embodiment of the Moopy-Lacka-Doo syndrome. It’s confusing, risky, and prone to leaving you in a state of bewilderment. So, if you’re considering investing in this ETF, make sure you have a sense of humor and a sturdy pair of financial roller skates. You’re going to need both.

This is the closing paragraph of ChatGPT’s response to “write a funny blog post critical of the alerian mlp etf”. You can read the full piece here.

It’s like a broken seesaw with a weight limit that only exists to crush your hopes and dreams.

It has no substance, and is short of facts compared with, say, our recent missive, AMLP Has Yet More Tax Problems. But it uses more colorful analogies.

It’s like riding a rickety old roller coaster with no safety harness while juggling chainsaws.

ChatGPT is not burdened with having to write in the fair and balanced way SEC regulations require. Our AMLP pieces seem quite tame by comparison. Perhaps this is how a future roboadvisor will persuade clients to dump AMLP for a more properly structured fund, part of fixing portfolios acquired from the underperforming human FA.

I couldn’t resist emulating the NYTimes journalist with Bing, but ChatGPT dryly responded to my overture, “As an AI language model, I don’t have the capability to experience emotions or form personal attachments.” The programmers can learn too.

AI is fast becoming the must-have acronym. Until recently it was ESG. That always looked like a fad to us. ESG Is A Scam and ESG Has No Clothes resonated with our investors and readers. ESG’s relevance doesn’t extend beyond its impact on fund flows.

Advisor-managed client portfolios are mostly lagging the S&P500 this year, because who can run a portfolio with just five stocks (Microsoft, Amazon, Nvidia, Alphabet and Meta)? When the other 495 companies in the S&P feel underappreciated, you know what’s coming next. Those slides in the generic investor presentation dedicated to ESG or the energy transition will soon be amended to demonstrate the company’s AI bona fides.

The energy sector has been using “machine learning” (what AI used to be called) for years. Enbridge promotes it in their management of wind farms. EOG Resources has earned industry respect for its use of analytics to optimize its E&P activities. As far back as 2017 they were extolling their use of real time data to improve operating performance.

Last year Williams Companies partnered with Context Labs to improve their delivery of clean energy using AI.

Exxon Mobil uses “autonomous drilling” relying on AI in Guyana. Chevron,  Occidental and Shell all publicize their use of AI. Before long not using AI will be the exception, the story worth reporting.

And of course, the computers running AI software require energy, so the sector can benefit both by operating more efficiently and from increased demand for its output.

In the late 90s every company needed a dot-com strategy. Remember Pets.com? At the time ordering pet food online seemed as ridiculous as buying books. But not to Jeff Bezos. Just as with the adoption of the internet, even when it became ubiquitous companies still made sure investors knew they were adopting the new technology.

AI is not a fad. But it’s not as new as it looks either. And it can generate some startling images.

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Machine learning existed long before it was rechristened. Genetically modified food seems recent but really goes back millenia. Vaclav Smil has chronicled how the world’s reliance on just a few varieties of grain for nutrition can be traced back to experimentation in the fertile crescent, when early humans were evolving from hunter-gatherers into farmers.

The market has already anointed the big winners from AI. But many more companies have been using machine learning, dynamic data analysis or continuously optimized algorithms for years. Expect to hear more of them boasting about it.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Last November SS&C Alps Advisors, the people who manage the Alerian MLP ETF (AMLP), admitted that they’d screwed up calculating the taxes owed by their fund. Mutual funds and ETFs don’t pay taxes as long as they comply with the rules of the 1940 Investment Company Act for an exemption. AMLP does not comply, because it invests in Master Limited Partnerships (MLPs). Owning more than 25% renders a fund non-RIC compliant and therefore liable for taxes like any other American company. AMLP is 100% MLPs.

We have written tirelessly on the topic (see MLP Funds Made for Uncle Sam). Last December we noted AMLP’s reduced NAV (see AMLP Trips Up On Tax Complexity) which fell 3.9% at their November fiscal year-end. Because of its flawed structure concentrated on MLPs and thereby liable for corporate taxes, AMLP has a five year annual return of 4.97%. The Alerian MLP Index, which it seeks to track, has returned 7.42%. The 2.45% difference is partly AMLP’s 0.85% annual management fee, but mostly the burden of taxes. By contrast, the investible American Energy Independence Index (AEITR) has a five year return of 11.06%.

Nobody would create AMLP today. MLPs are around a third of the sector, and their numbers continue to decline. It is a relic of a decade ago when the MLP structure dominated. That is no longer the case.

Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) a couple of weeks ago caused smaller MLPs to briefly catch a bid as traders calculated the rebalancing within a shrinking pool the loss of MMP would cause for AMLP. The OKE-MMP transaction is looking less likely, as explained later in this blog post.

Nonetheless, AMLP is still the sector’s biggest ETF by a considerable margin. That AMLP retains any holders is confirmation that inertia and benign tolerance still inform investment decisions for some.

November’s tax-based NAV correction wasn’t the advisor’s last word on the issue. Last week they provided a tax update that, “modified the estimate of the Fund’s deferred tax liability” by $188 million, an additional 2.27%.

This will push AMLP’s five year underperformance against an index that has itself severely lagged midstream energy infrastructure to close to 3%.

Since November, AMLP’s NAV has been adjusted down by over 6% as Alps hopes it has finally got its arms around the complex tax issues the fund faces. Their lawyers, who will have carefully drafted the latest press release, wisely added, “The Fund’s estimates regarding its deferred tax liability are made in good faith; however, the daily estimate of the Fund’s deferred tax liability used to calculate the Fund’s NAV could vary significantly from the Fund’s actual tax liability.”

In other words, there could be more to come.

There must exist a hardcore group of AMLP investors who resemble the reliable and extreme primary voters of either political party. They accept their flawed choice with no regard for continued evidence of his (her) failings, because to change now would mean conceding an earlier error. There is no helping these investors. They fork over $50 million in management fees annually to an advisor who has now made two tax errors equal to multiples of that.

But there also exists a swathe of financial advisors holding AMLP for clients whose fiduciary fitness can be questioned by having selected such a poorly run, anachronistic fund. You may be one of these advisors, or you may be a client of one. $405 million of tax-related restatements is starting to look like a situation best avoided. Perhaps a class action lawsuit will seek to restore some of those losses out of past management fees.

AMLP now reports a Deferred Tax Liability (DTL) of $373 million (as of June 2, 2023). Market appreciation will create additional unrealized gains and an increased DTL, which will act as a headwind in a rising market.

The case for not owning AMLP could not be clearer. In fact, its best use may be as a short position, as we’ve noted in the past (see Uncle Sam Helps You Short AMLP).

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Investors in OKE and MMP will be encouraged to see a widening spread between MMP’s price and the value of OKE’s proposed acquisition. This means traders are increasingly skeptical that the deal will get done. Since the announcement on May 12, OKE is down 8% and MMP is up only 11%, half the promised premium. The AEITR is +2.5%. It’s one of those rare transactions that is bad for both sides (see Oneok Does A Deal Nobody Needs). OKE gets higher leverage and MMP investors face an unwelcome tax bill.

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Hopefully it’ll get voted down. We calculate the market-implied odds of it going through are now barely above 50/50*.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

*The probability of the deal happening is estimated as follows:

Let:

MMP = current price of MMP

MMPD = price of MMP implied by deal

MMPND – the price MMP would drop to if the deal was canceled, which is assumed to be its pre-deal level adjusted for subsequent move in sector as defined by AEITR.

Deal Probability, or DP = (MMPD-MMP)/(MMP-MMPND)

Therefore, odds of No Deal = 1-DP

Right up until the last minute, environmental extremists continued to use the court system to stymie completion of the Mountain Valley Pipeline (MVP), which will move natural gas from West Virginia to Virginia. Permits have been issued by too many Federal and state agencies to list here. Extremists led by the Sierra Club with their agenda of limiting energy access continued their relentless abuse of the courts seeking the overturn of previously issued permits.

On Friday, the US Court of Appeals for the District of Columbia agreed that the Federal Energy Regulatory Commission (FERC) had “inadequately explained its decision not to prepare a supplemental environmental impact statement.”

This is how infrastructure projects get held up. The US judicial system is ponderous and unpredictable, which can shred IRR estimates. It’s why nuclear power plants don’t get built. And the same technique is already impacting the build out of renewables. Nobody wants transmission cables built near them.

Equitrans, the main owner of MVP, has struggled for years to overcome legal obstacles and complete the remaining few miles of the pipeline so it can be put into service. A 98% completed pipeline doesn’t generate cashflow. Senator Joe Manchin (D-WVa) thought he had an agreement to pass permitting reform that would have ended the legal challenges to MVP when he threw his support behind the Inflation Reduction Act (IRA). But the expected new legislation never came, as support from both parties melted away.

West Virginia is coal country, and Manchin’s support of the IRA, which includes features intended to drive coal consumption down, has made him one of America’s least popular senators. He’s running for re-election next year and has said he’d vote to repeal the IRA if given the opportunity. Manchin’s Republican opponent Governor Jim Justice has a higher approval rating than Manchin in the state even among Democrats.

Improbably, the debt ceiling legislation is being used to help Joe Manchin’s re-election prospects because a policy rider attached to it supercedes existing legal challenges. The draft legislation includes the following language:

Congress (1) ratifies and approves all permits for construction and initial operation at full capacity of MVP through Secretary of the Army, FERC, Secretary of Agriculture and Secretary of Interior (together, the “Federal Agencies”), (2) gives 21 days from enactment for the Secretary of the Army to give permits for MVP to cross waters and operate, (3) provides judicial review whereby no court has jurisdiction to review any action by the Federal Agencies, including any pending lawsuits (importantly removing the overhang from 4th Circuit, which vacated the WV water permit), and (4) directs any claim against the validity of this law to the DC District US Court of Appeals.

In other words, Congress makes completion of MVP a matter of law, greatly reducing although not eliminating the power of the courts to continue blocking it. That a virtually completed pipeline still requires specific congressional legislation to cross the finish line shows how broken is our country’s permitting of new infrastructure. Climate extremists won’t be happy with MVP, but deployment of renewables infrastructure is at least as vulnerable to similar abusive tactics of the court system.

Equitrans (ETRN) stock jumped yesterday on the news. We had felt its prior valuation assumed MVP would never go into service, so it offered a free call option on its completion. NextEra, a partner in the project, wrote their interest down to zero last year (see High-Energy Earnings Boost Pipelines).

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Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) is quietly losing support. As we’ve noted (see Oneok Does A Deal Nobody Needs) many MMP investors will face a bill for the recapture of deferred taxes. Advisors who own MMP in separately managed accounts will need to explain this to every client, and since deferral of taxes is often the point of owning MLPs, this isn’t a conversation they’ll approach enthusiastically.

OKE’s stock has sunk 10% since the deal was announced, so their investors are less enamored of the promised $1.5BN tax shield (obtained at the expense of MMP unitholders) than they are dismayed at the jump in leverage to 4.0X to finance the deal.

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There are plenty of stakeholders who could find it in their interests to vote no. We calculate the odds of it going through have slipped noticeably, although still more likely than not. Both management teams face an uphill battle persuading investors to approve the deal. As we’ve mentioned before, as owners of equity in both OKE and MMP we’re going to use both opportunities to vote no. We would have preferred to see MMP combine with another MLP, which could have avoided the deferred tax recapture.

MLPs were also noticeably weaker than c-corps yesterday, unwinding some of the boost the smaller ones had received in anticipation of Alerian having to rebalance its index (see Alerian Still Clinging On). This confirms the market’s revised assessment of the probability of the deal closing.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

An unintended side-effect of Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) has been to give a bid to smaller MLPs. This has come about because of the shrinking pool of names available to populate the Alerian MLP Infrastructure Index (AMZIX) and the Alerian MLP ETF (AMLP) which tracks it.

AMZIX recently increased its maximum weights, from 10% to 12%, because there aren’t enough MLPs. Even before the OKE/MMP transaction NuStar Energy (NS) and Crestwood (CEQP) were both weighted at 3.5X their respective share of MLPs and more than 5X their weight in the American Energy Independence index (AEITR).

MMP is currently the biggest holding in the AMZIX, at 12.5%. NS and CEQP have both performed strongly since the announcement as traders anticipate a reallocation towards them and other small names once the deal closes.

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It’s been good for most MLP investors, other than MMP because of the unwelcome recapture of deferred taxes. The worst place to be in the sector has been a market cap-weight investor in OKE and MMP. That combination has underperformed AMZIX by 6%.

Had you been able to trade on the inside information that MMP was being acquired, you would have done better to buy CEQP than the target company itself. It’s a pity for the deal’s proponents that the uninvolved MLPs can’t vote, because it’s been better to be an observer than a participant.

This is the distortion that AMLP’s anachronistic structure is causing.

It may sound churlish to knock AMLP when the MLPs which are 100% of its portfolio have just outperformed. But over the past decade AMZIX’s 0.6% annual return lags the AEITR by 11%. Concentrated MLPs haven’t been nearly as good as diversified midstream energy infrastructure.

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The deal still has to be voted on by the owners of both companies. We own both and will be voting against it twice. The market assesses the transaction as likely to close, although the odds have dipped in recent days. The discount to the deal price divided by the deal premium can be thought of as a rough expression of the odds of a successful completion. We estimate current market prices suggest a high likelihood of 82%, although this is down from 90% early last week.

JPMorgan reported on the weekend that “investor feedback appears mixed to negative on the deal.”

Based on comments our blog has received and other feedback, people are generally against but not all are. One thoughtful reader noted that as a long-time MMP holder living in a high tax state he was already paying 50% on his distributions. He added that MMP management, “… have done an absolutely incredible job – just look at MLP returns over the last 20 years without MMP as evidence. I trusted them all the way and I tend to still trust them in this case to have done their best for their shareholders.”

Another reader, retired tax attorney Elliot Miller, warned that, “In addition to the capital gains taxation due to adjusted basis in MMP units having been reduced by tax deferred distributions, MMP unitholders will have significant ordinary income taxed resulting from depreciation recapture even after the release of suspended passive activity losses.”

I had noted that many MLP investors plan to donate their units, thus eliminating the recapture of deferred taxes. But another reader quoted an IRS publication on the topic:

Donated, publicly traded partnerships – in particular master limited partnerships (MLPs) – are an important exception to the typical fair market value deduction for long-term gain securities, as the charitable deduction must be reduced by the amount of ordinary income that would have been realized if the property had been sold at fair market value on the date contributed.

These comments reflect the complexity of MLPs when it comes to taxes. Many MMP unitholders likely won’t know their precise tax outcome when voting on the transaction.

C-corps and MLPs aren’t easily combined. Whenever it’s happened in the past, such as with Kinder Morgan and its MLP Kinder Morgan Partners in 2014, the MLP unitholders have been mistreated. If there was a case for MMP to sell itself, it would have been preferable to combine with another MLP. This would have avoided the tax issues MMP unitholders will now face.

But most importantly, the deal highlights the challenges facing AMLP with ever fewer names to hold. It’s too big to convert to a more diversified fund – although its holders should hope it never does because it would create a fire sale of MLPs. It remains the biggest ETF in the sector – hoping nothing else changes and that its investors don’t think too hard about what it owns. Nobody would create AMLP today. It’s clinging on.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Wall Street analysts are predisposed to be supportive of management’s M&A activities.  The sycophantic posturing that precedes an earnings call question with, “Nice quarter, guys” lives in the hope of investment banking business. Hence the response of sell-side analysts to Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) is one of mild surprise at this unlikely combination that stops short of overt criticism.

The numbers offer a less enthusiastic reception. OKE is –8% since the deal was announced, in spite of the $1.5BN tax shield and $200-400MM of annual synergies. MMP is up 13%, but this is well short of the 22% premium that heralded the deal because of OKE’s underperformance. In addition, MMP investors are facing the recapture of deferred taxes on prior distributions. This will be more for long term holders, which runs counter to the point of MLPs which is to allow long term management of tax deferrals by investors.

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It’s hard to see anyone other than a recent MMP investor being untroubled by the recapture. The cohort of long term MMP holders may be too small for their votes to disrupt the deal. MMP has presumably analyzed this closely. But financial advisors who hold MMP in client accounts will not relish explaining any unexpected tax bill to clients.

An investor who owned OKE and MMP in proportion to their relative market caps is down 2.2%. By contrast, the Alerian MLP Index (AMZX) has gained 4.8% since the deal, partly due to MMP’s jump but also because traders have anticipated a rebalancing from MMP once it disappears into the shrinking group of remaining MLPs. In other words, the investors who have done best out of this deal are the ones not involved in it.

If the transaction ultimately closes, enthusiasm will be muted. The proposed OKE acquisition of MMP is a solution to a problem nobody has.

Turning to the regional bank crisis — a few weeks ago I shared my experience as treasurer of our Naples co-op in trying to earn a fair interest rate on our cash (see Some Banks Are Having To Pay More). We recently switched banks and left the 3% deposit rate that we had only achieved through persistent complaints. Banks operate on the assumption that you don’t know where treasury bills or Fed Funds are.

Our new bank relationship began at 0.25%. The initial response when I requested a competitive rate was that I should point out a competitor’s rate and they would then consider the matter. I responded that 0.25% was so off-market that it was unworthy of such effort and that they were insulting my intelligence. Days passed with no response, and finally they improved to 2%. This is from a bank whose market cap has shed two thirds in the past eighteen months.

So we’re going to open a brokerage account and buy treasury bills which yield 5%. It creates some additional administrative work, but such offensive behavior demands it. This is how one regional bank will lose a $500K deposit. Banks behave as if we’re stupid, or lazy. Their prior experience may justify such a stance, but it hardly seems like a stable business model to hold your customers in such low regard.

The question regional bank investors must answer is whether large numbers of depositors will react like us. Banking services need to be paid for. Banks rely on paying a discounted rate on deposits. The last time Fed funds traded above 2.5% was in 2008 before the Great Financial Crisis (GFC). Since then, deposit rates near zero haven’t represented much of an opportunity cost for customers.

Now they do, and in the intervening fifteen years moving money and gaining access to information have only become easier. Banks don’t seem willing to create linked brokerage accounts that can own treasury bills, and information about deposit rates for business clients is kept intentionally opaque. They don’t make it easy.

Nonetheless, foregoing a couple of per cent on $250K might strike many depositors as a steep price to pay for banking services.

If competitive pressure forces deposit rates higher, net interest margins will be squeezed. The argument against marking to market bank holdings of securities rests on the notion that deposits are sticky and when rates are rising the value of that stickiness (ie the discount to treasury bill yields) increases. But this is based on past behavior. How depositors reacted to rising rates prior to the GFC may not be a useful guide today. Deposits can leave, at times quickly. Regional bank investors will find out in the months ahead how responsive savers are to more competitive rates from the US Treasury.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Oneok Inc (OKE) surprised sell-side analysts with their Mother’s Day acquisition announcement of Magellan Midstream, LP (MMP) at a 22% premium. Anticipated synergies of $200MM aren’t that big for the $18.8BN transaction value. Management expects that to reach $400MM+ but nobody can ever tell after the fact whether it happened or not. And given the merged entity’s $60BN enterprise value, it’s insignificant.

By resetting the cost basis of MMP’s infrastructure assets, OKE expects to realize tax deferrals with an NPV of $1.5BN. Critics assert that taxes are the chief motivation with few visible benefits from synergies. Moreover, the tax benefits are coming from long-time MMP unitholders, for whom the transaction is defined as a sale of their MMP holdings.

MLP investors enjoy tax-deferred distributions, because the K-1s allow them to include their proportional share of the business’s depreciation in their tax returns. Eventually this tax has to be paid, usually when the investor decides to sell. Making a charitable donation of MLP units is one way to avoid the recapture of deferred taxes. Another is to never sell, instead leaving the investment to one’s heirs who acquire the units with a current cost basis.

The least attractive way to deal with the deferred taxes is to be forced to pay them when the company decides to sell. This is what MMP has done. Tax impacts vary by length of ownership. The longer your ownership the bigger your tax recapture. Recent MMP buyers aren’t much impacted by this.  Your blogger, a long-time MMP investor, is at the less pleasant end of this range.

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MMP is treating its investors in a similar way to Kinder Morgan when they rolled up Kinder Morgan Partners (KMP) into the parent c-corp in 2014. As well as a tax bill at a time of management’s choosing, KMP investors were also stuck with a reduced dividend. Nine years later former KMP holders remain bitter.

MMP can calculate the recapture liability for all their unitholders. On Monday’s call to discuss the deal, management noted that the $25 per MMP unit cash component was based on the aggregate tax liability of MMP unitholders. Assuming they use the cash portion of the deal to pay taxes generated by the transaction, Wells Fargo calculates that the average MMP investor will suffer a 38% distribution cut. Long-time investors will do even worse, because they’ll have a bigger than average tax liability. MLP investors are highly attuned to taxes, which is why they tolerate the K-1s. A significant percentage of MMP holders will face a tax liability in excess of the cash component. They won’t be happy.

Many investors own both companies. OKE likes the diversification provided by MMP refined products pipelines, but investors already had that as separate entities. By Tuesday’s close, the 22% premium had shrunk to 13% because OKE dropped 11% since the announcement. This increases the proportion of MMP unitholders who are net worse off from the transaction after calculating the tax recapture. An investor who holds both names in proportion to their market cap has lost more on OKE’s slump than she’s gained from MMP’s rise. And that’s before adding in the cost of the recapture of taxes deferred on prior MMP distributions. The market regards this as a value-destroying transaction. It’s not even clearly good for MMP investors alone because of the recapture.

A simple way to think of the transaction is to imagine that you owned 100% of both companies. Would you borrow $5.1BN, like OKE, to pay deferred MMP taxes in exchange for a tax shield from the stepped-up cost basis? Few of us would take on debt to pay taxes sooner rather than later. Moreover, MMP investors are there for the tax deferral and have lost it. By contrast, OKE investors care more about the increased leverage than the tax shield offered by acquiring MMP assets, as shown by the weakness in OKE since the deal was announced.

Small MLPs initially performed strongly on the news, because MLP-dedicated funds like the Alerian MLP ETF (AMLP) will have to rebalance away from MMP by investing in the ever-diminishing pool of MLPs. For example, Crestwood LP (CEQP) rose 8.5% on Monday as traders anticipated this inflow of index-constrained buying. Energy Transfer LP (ET) didn’t react the same way because it’s already at its position limit in AMLP’s index.

There’s nothing about the OKE/MMP transaction that is intrinsically bullish for CEQP or other MLPs. Traders are positioning ahead of a rebalancing. The MLP structure is out of favor compared with the more conventional c-corp because of its limited investor base. Most institutional equity investors are tax exempt and face onerous taxes if they invest in partnerships. Retail investors dislike the tax complexity of K-1s.

This leaves US taxable, K-1 tolerant buyers – wealthy individuals and taxable institutions. This includes the poorly structured AMLP, which will have to accrue for taxes once more when market appreciation turns its unrealized losses into gains. So it’s hard to interpret one more MLP going away as a reason to own a concentrated portfolio of MLPs, even though MLP-dedicated funds did receive a performance bump on Monday.

The combination looks unattractive all round. SMA managers will be explaining to clients for whom they own MMP why a strategy designed to defer taxes has instead presented an unwelcome tax bill. It tarnishes the entire MLP structure, because being a long-term investor brings increased exposure to another MMP deal with sudden tax recapture. It’s unclear why investors in either company should vote to approve. We own both OKE and MMP. That will give us two chances to vote no.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Last week the WSJ warned that We May Be Getting Used To High Inflation. Only 9% of respondents in a recent survey think inflation is our most important problem. Government leadership (presumably the absence thereof) and “the economy in general” were both bigger concerns.

Americans are learning to live with higher inflation. The University of Michigan shows that one year inflation expectations among consumers have been rising all year. The Employment Cost Index is increasing at 5%, a figure generally felt to be inconsistent with 2% inflation. The Fed’s preferred Personal Consumption Expenditures (PCE) deflator has been above 3% for two years. These are all signs that households and businesses are adapting to a world of 3-4% inflation, not 2%.

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The bond market tells a different story. The spread between ten year treasury notes and TIPs implies investors expect CPI to average around 2.3% over the next decade. By this measure, markets have never been that worried about persistent inflation. It’s remained below 2.5% for most of the past year.

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TIPs ought to be a reliable indicator, because return-seeking bond buyers are presumably putting considerable thought into their purchases. But to this observer it looks likely that years of Quantitative Easing (QE) along with $TNs held by foreign central banks (China; Japan) and others who want returnless liquidity have distorted the message bonds would otherwise communicate. Bonds are a broken indicator.

WSJ writer Greg Ip thinks Americans getting used to higher inflation “very bad news”. He’s right if the Federal Reserve regards embedded inflation expectations as in need of further monetary attention. But it’s not clear that 3% or 4% inflation is worse for real GDP growth than 2%.

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Since 1990, five year trailing CPI inflation has ranged from 2-4% and had been slowly declining until the pandemic-induced jump. There is no statistical relationship with real GDP growth. That doesn’t mean that inflation doesn’t matter, but the data shows that if it’s relatively stable 2% isn’t any better than 4%. Central bankers have made 2% a religious tenet. It’s really a shibboleth.

Raising the debt ceiling will soon become the biggest concern of market participants, since negotiations look likely to reach or even pass the deadline. A rare flaw in the US constitution separates spending decisions from financing ones – Congress ought to raise the debt ceiling whenever they approve a budget. The debt ceiling standoff is what passes for serious consideration of America’s fiscal outlook in Washington, so every couple of years we wonder whether this game of chicken will go wrong. US credit default swap spreads are wider than Greece.

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Our projected indebtedness is familiar with no solution in sight. The deficit barely registers as an issue. Politicians who suggest raising taxes or cutting spending soon get dumped by voters and move on to the more lucrative business of lobbying.

The Fed deserves their share of blame. Fifteen years of QE has held bond yields down, muting whatever warning of fiscal profligacy higher yields might otherwise transmit.

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More recently, higher interest rates have brought various terrible milestones closer by two to three years (see How Tightening Impacts Our Fiscal Outlook). The February 2023 edition of The Budget and Economic Outlook, published by the Congressional Budget Office, was updated for the Fed’s tighter monetary policy compared with the previous publication in May 2022. Debt:GDP will now cross 100% in 2024 rather than 2027. Annual interest expense will reach $1TN in 2028 not 2030.

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Inflation is the friend of the inveterate borrower. It reduces the real value of obligations. Our fiscal outlook will benefit if debt growth lags nominal GDP. Low interest rates, especially negative real rates, help. 4% inflation leaves more room for real yields to be negative. 2% doesn’t, and as we’re seeing the effort to get inflation back to 2% is making our fiscal outlook worse.

Throughout history governments have eased their debt burden through currency debasement. I explained why this will be America’s solution a decade ago in Bonds Are Not Forever. Developments since then confirm this outlook. There’s little reason to expect spending cuts or tax hikes because there are no votes in it and no apparent cost to current policies. Today’s biggest economic disruption is coming from the Fed’s efforts to restore inflation to 2%. Regional banks and the Federal government need lower rates. There’s a fiscal cost to tight monetary policy.

We can lower inflation or our debt burden. We can’t do both. They are mutually incompatible objectives. We are already learning to live with 4% inflation. It’s not that bad. It’s the path of least resistance.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

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.

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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

Inflation Fund