Readers know not to expect bearish views on energy from this blog. A year ago, we offered ten reasons why we thought the outlook was positive (see The Upside Case For Pipelines – Part 1 and Part 2). We were right about the direction but not all our reasons played out. Below is a report card:

1) Investors become convinced financial discipline will continue Grade: A

Growth capex has remained well contained for the most part. The two big Canadians continue to have outsized investment programs, and together make up almost half of the industry’s total even though they’re just over a quarter by market cap. They both have large business segments within Canada that enjoy highly predictable returns, and as a result both trade at a premium (EV/EBITDA) to the market. Wells Fargo expects growth capex to drop from 41% of free cash flow last year to 35% by 2027. Assuming the trend continues, the market is likely to reward the sector.

2) Pragmatism guides the energy transition Grade: B

California and parts of New England continue to pursue self-destructive policies that in effect accommodate continued emissions growth in Asia ex-Japan while enduring higher costs and less reliability. Most other regions of the US are adopting a more balanced approach. Solar and wind were 12% of US power generation in 2021, and 4.7% of total primary energy consumption. There’s much more to energy than generating electricity. The EIA expects solar and wind to reach 16% of power generation in 2023. Thanks to approaches that vary by state, the US energy transition is less disruptive than the European model.

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3) Real yields continue to fall Grade: F

Surprisingly (to us), real yields on ten-year treasury notes have risen by 2.5% this year, from –1% to +1.5%. We had felt negative real yields would drive more investors into income-generating assets, including midstream energy infrastructure. Tightening financial conditions were a headwind for almost all sectors, but not energy. Excessive government indebtedness is likely to limit the economy’s tolerance for high interest rates. Real yields will at some point resume their long-term decline.

4) Inflation surprises to the upside Grade: A

The Fed got this spectacularly wrong. A year ago they expected 2022 inflation, as measured by their favored Personal Consumption Expenditures (PCE) index, to run at 2.6%. They’re now at 5.6%. Private forecasters were also mostly wrong. In April JPMorgan was forecasting 2022 CPI of 5.5%, but now they’re at 7.4%. For 2023 the Fed is forecasting 3.1% (PCE) and JPMorgan 2.8% (CPI). This outcome would represent victory for the Fed. Inflation will fall, but the risk to these forecasts remains to the upside.

5) Republican mid-term gains squash any anti-energy sector legislation Grade: C

Poor candidate selection led to muted Republican gains and failure to regain control of the Senate. Regulatory reform that Joe Manchin thought he’d won in exchange for supporting the Inflation Reduction Act has still not passed. The Mountain Valley Pipeline, built but unused, would be the most tangible beneficiary but renewables advocates should recognize that construction of high voltage power lines will also suffer from the current regulatory uncertainty confronting many types of infrastructure construction. Nonetheless, Democrat policies favor energy investors by discouraging capex, thereby boosting cash flow. Hug your local climate protester and drive them to an event.

6) Sector fund flows turn positive Grade: C

Flows into midstream energy infrastructure funds were negative for the sixth straight year, albeit better than 2021 at $1.1BN through November 2022 vs $1.7BN (same period 2021) according to JPMorgan. Wells Fargo estimates 2022 buybacks at $4.8BN, so sales by retail investors are being easily absorbed by the companies themselves. 2023 buybacks are forecast at $5BN. The sector’s increasing cashflow remains a positive flow of funds story.

7) Cyclical factors that are bullish Grade: A

Goldman’s Jeff Currie believes the ESG movement is distorting the normal capex cycle of the energy sector because high commodity prices are not spurring the type of investment in new production that might otherwise be expected. The result is an extended cyclical upswing, benefiting investors if not consumers.

8) Geopolitical factors that might surprise Grade: A

World events that shock usually hurt equity markets. Energy is different, in that conflict often raises prices and makes energy security more valuable. We had no insight about Russia’s invasion of Ukraine, but US LNG exports are an unsurprising winner. For the first half of 2022 the US was the world’s biggest LNG exporter.

9) Covid loses its ability to disrupt Grade: B

The world finally moved on, except for China where rolling citywide lockdowns reduced growth and demand for oil. China’s recent pivot to dump virtually all restrictions will allow the economy to rebound.

10) Energy transition Grade: A

2022 showed the importance of “dispatchable” energy, meaning energy that’s there when you need it as opposed to when the weather permits. Western Europe didn’t scramble to buy more windmills as Russian natural gas flows petered out. They bought more LNG, especially from the US, and consumed more coal. Policymakers are increasingly accepting that solar panels and windmills aren’t the complete solution. Moreover, traditional energy companies are turning out to be vital to reducing greenhouse gas emissions. The Inflation Reduction Act has boosted investment in carbon capture projects. NextDecade is signing contracts to export LNG for which emissions generated during processing have been captured. The energy transition has gone from threatening the energy sector to providing opportunities.

Midstream energy infrastructure had a great year in spite of a few misses on our report card. Fundamentals that were good a year ago remain so. With free cash flow almost 2X dividends, buybacks increasing, and capex still constrained, 5-6% yields still look appealing.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Consumer sentiment is as bad as 1980 when inflation was 13%. The Fed funds rate swung from 17% to 9% before peaking at 19% in early 1981. Eight US marines died in Iran in a failed attempt to rescue our hostages. John Lennon was shot. No wonder Ronald Reagan won election later that year. Consumers today are more negative than they were back then.

The put/call ratio is close to the extremes of the Great Financial Crisis in 2008 when Bear Stearns was bailed out by JPMorgan and Lehman failed. There’s plenty of negatives, but are prospects really that terrible?

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If you’re not yet convinced of pervasive bearishness, how about that for the first time in 25 years US equity strategists are forecasting a down year.

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Conventional portfolios did poorly. Diversification and a dollop of fixed income have caused misery. Energy and cash was the improbable winning combination. Meme stocks, tech and bitcoin (useless except when it’s going up) have slumped along with animal spirits.

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But everyone who wants a job has one, albeit pay is lagging inflation. We’re not at war, although between Ukraine and Taiwan there’s plenty to worry about. And it looks like we handled covid rather better than China even though they had a head start on us since it originated there.

If today’s outlook compares unfavorably with 2008 or 1980, you have to conclude that people expect more out of life. Warren Buffet famously said that the secret to a happy marriage is to marry someone with low expectations. At moments of marital discord, I’ve pushed my luck by sharing this wisdom with my wife, who retorts that her expectations couldn’t be any lower.

Perhaps happiness in life requires lower expectations than evidenced by survey respondents to the University of Michigan.

The Alerian MLP ETF (AMLP) may be a flawed investment product, but it still has its uses. It serves as a reminder of what an ETF should not be, which is a payer of corporate taxes. As regular readers know, AMLP doesn’t qualify to be exempt from taxes like virtually all ETFs and mutual funds, because it invests almost all its assets in MLPs. Our Byzantine tax code recently led to a 3.9% NAV hit for AMLP investors as its advisor Alps reassessed what they owed (see AMLP Trips Up On Tax Complexity).

AMLP is inadequate as a long-term investment because its taxable structure ensures it will substantially lag its index. But it can still be worthwhile as a short. One example is when market appreciation turns unrealized losses into gains. Upon crossing that threshold the tax drag kicks in, such that it goes up at 79% of its index (ie 1 – the 21% corporate tax rate) but still falls with the market. Such asymmetry can make it a useful hedge on a long portfolio of MLPs or even a good short position (see Uncle Sam Helps You Short AMLP).

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Another trade opportunity exploits the January effect. This used to be a feature of the S&P500 but has disappeared in recent years. It’s not that pronounced for the American Energy Independence Index (AEITR), but still shows up in the Alerian MLP Infrastructure Index (AMZIX), which AMLP seeks to track minus the tax drag and expenses.

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The likely reason for a positive start to the year is that MLP holders tend to be K-1 tolerant, US taxable Americans. Because K-1s are a pain in the neck, if you’re contemplating selling an MLP December is better than January because you’ll avoid one last K-1 for the stub year. Similarly, purchases delayed until January avoid a K1 for the last month of the prior year.

Over the past decade, the AMZIX has averaged +3.3% in January, versus 0.5% for all months. Seven out of ten Januarys were positive, and only one was down more than 5% (2020). On average it’s up around half the time. If you’re inclined towards trading, buying AMLP now and planning to exit next month has an attractive risk/reward. And if you’re thinking of investing in the sector, delay is likely to mean paying higher prices. Just don’t make AMLP a long-term holding, because with its tax structure and absence of the biggest pipeline corporations it’s likely to continue underperforming the sector.

The seasonal January AMLP trade might benefit from a macro backdrop that suggests more investors than usual are hedged, defensive, in cash and hunkered down. In addition, the fundamentals for midstream energy infrastructure remain positive as tirelessly reported on this blog (see Energy – The Only Bright Spot In 2022). And if you already own AMLP, late January could be your best chance to swap it for a fund with a more investor-friendly structure.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Christmas pudding is among my favorite traditions of the season. Like marmite, it’s only offered by English parents, and failure to acquire a taste when young quickly becomes permanent. Our children were offered a perfunctory opportunity and only one chance at rejection, a rule I imposed to ensure an adequate supply for the rest of us.

My wife secured three this year, a compromise only reached when I warned of plenty of capacity in my suitcase for imports during a trip to London. She can rightfully claim to be guarding my health – a typical recipe includes a pound of suet (animal fat). A portion is correctly served heated and bathed in heavy cream, and the first slice always appears inadequate. One year my mother betrayed uncommon agility in securing the remaining slice for seconds. She is my only real competition. My grief was poorly disguised, which is why this year we have increased supply.

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International travel finally returned. For three years we stayed in the US, unwilling to gamble with the mandatory covid test prior to coming home. How do you ask friends if you can extend your stay so as to self-quarantine? My wife and I made many domestic trips, and where possible saw clients as well. I love investing, but an unexpected bonus is to share objectives, investment outcomes and a meal with like-minded people. This year offered more opportunities than in the past. I know each friendly reception was genuine, but energy’s outperformance provided agreeable circumstances.

It’s rare to be jealous of one’s children. But I was envious of our younger daughter’s four-month semester abroad in London. She seized every conceivable weekend tourist opportunity, mastering European travel on a student budget (in truth modestly subsidized). She finally returned to the US last week, the best Christmas gift.

It’s four decades since I left the UK, and every trip back is too brief to see everyone. We shan’t live there again, but one week a year is inadequate to stay in contact with those worth the effort. And I miss going to English football games. My son and I watch most of Arsenal’s games on TV. I cherish our time together but still miss being there in person. I shan’t be a regular at Arsenal Football Club but in future will aim for at least two visits a season.

Nostalgia is Christmas, as is the chance to make new memories for tomorrow. Our Christmas traditions were formed in England and persist through our children today. When my six-year-old granddaughter solemnly reports on her meeting with Santa Claus, it reminds me of her mother as an adorable little girl a generation ago but also informs future reminiscing. Fond memories combined with youthful hope are a delicious recipe – family, fellowship and adequate dessert make it close to perfect.

To our friends and clients, whatever challenges you faced in 2022, energy was assuredly a bright spot and hopefully not the only one. From SL Advisors we wish all of you a wonderful holiday season and a prosperous 2023.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

My visceral reaction upon reading headlines such as Martin Wolf’s “Glimmers of light in a terrible year” in the Financial Times is to counter with positives. I am a glass half full guy, a prerequisite to navigating 2015-20 when pipeline stocks lagged the S&P500 for five years out of six. Wolf says, “Few will regret the passing of 2022” and I must temper my instinctive opposition to such negativity because war broke out in Europe and many families, including my own, lost a loved one. My stepmother sadly passed away in January, and I have only fond memories of her.

But for those who malign 2022 simply because of lousy investment returns, poor asset allocation is the cause. More energy exposure and no bonds would have made the year more agreeable. The case against bonds was so obvious and has been so tirelessly repeated here for years that readers will be spared another exposition (for more detail, see The Continued Sorry Math Of Bonds).

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Suffice it to say that central banks starting with the Federal Reserve ($8.5TN), sovereign wealth funds and other return-insensitive buyers have rendered the entire asset class useless to the discerning investor. The Kansas City Fed estimates that Quantitative Easing has lowered ten year treasury yields by 1.6%. What more does a retail bond buyer need to know? For risk reduction just own cash. Duration is for dummies.

The long 2015-20 dark period convinced many that an allocation to energy was a problem they didn’t need. Equal measures of stubbornness and detailed analysis are character traits of those who remained. By 2020, five out of six underperforming years was definitive to some. Two years later it’s five of the past ten. It was simply a bad run. Investors for whom 2022 will shortly be a fond memory had an overweight to energy, and in many cases to midstream energy infrastructure.

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The American Energy Independence Index (AEITR) is +18% YTD, versus –13% for the S&P. One investor estimated that his 2.5% allocation to pipelines had generated almost 1% of outperformance. Wells Fargo notes energy’s rising weight in the S&P500 and concludes it will force more generalists to allocate something if not take an equal weight position. When energy was 2% of the market, a zero weighting might not cause much tracking error. But when energy is 5%, being uninvested during outperformance will be readily apparent to clients.

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Investors are enjoying the persistence with which pipeline companies are returning cash. Dividend yields of 6% are augmented with buybacks which Wells Fargo estimates will add a further 1% pa to returns over the next five years. Before the shale revolution, MLPs which were then the dominant business structure paid out 90% of their distributable cash flow. Buybacks were unknown. Today the sector is paying out around half its free cash flow in dividends, keeping capex low, reducing leverage and buying back stock. If the widely forecast recession occurs a year from now, this sector will be well positioned to maintain payouts and emerge unscathed.

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US LNG will enjoy strong demand for many years, even though exports won’t increase much until additional export infrastructure is completed in a couple of years. European and Asian benchmarks are far higher than the US, easily covering the cost of transportation.

NextDecade announced another sale and purchase agreement yesterday with Portuguese buyer Galp Trading. NextDecade expects to announce final investment decision on a three train LNG export facility next quarter. That would likely mean gas, and cash, would start to flow by 2027.

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The announcement arrested a steady decline in NextDecade’s stock, which has lost almost half its value since peaking in August. It’s still some years until the company will be valued on free cash flow yield. The market may be recalibrating how much dilution equity investors will endure as they raise capital for a project that will likely cost over $10BN. The current market cap is just over $500MM.

An alternative view is that recent weakness reflects a broader exit from volatile names. Curiously, over the past six months NextDecade is more correlated with Tesla than with the S&P500 or the AEITR. The companies have nothing in common, other than perhaps both being on the right side of the energy transition. One day NextDecade may provide the LNG that foreign utilities will burn to generate the electricity that moves electric vehicles.

Capital discipline, ample dividend coverage and energy’s growing weight in the S&P500 all underpin what we believe is a positive outlook for the pipeline sector heading into 2023. Moreover, ‘40 Act funds in the sector continue to experience outflows (though happily we are seeing inflows). As this retail selling exhausts itself it should provide further upside.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

For the first time in history, nurses who work for Britain’s National Health Service went on strike last week. They’re demanding a 19% pay increase, to make up for current inflation as well as the “20 per cent that has been eroded” from pay over the past decade, according to union leader Pat Cullen.

Nurses in the UK occupy a special place in the public consciousness, evoking memories of Florence Nightingale who led a team of 38 to treat wounded soldiers during the Crimean War in 1854. Underpaid yet much loved is how many Britons feel towards them. In Germany, average pay for nurses is €33K ($35K). The US median is $78K.  The average British nurse makes £26K ($32K). Some report relying on patients’ food at the end of the month while awaiting their paycheck.

Europeans are supportive of unions and tolerate strikes more than the US. Traveling by train from London to Paris last Friday, our daughter was advised to allow extra time to pass through Immigration, thanks to Brexit. The transit system faced another strike the following day, and her (perhaps over-protective) father reminded her not to get sick while the nurses were on strike.

The problem is that workers in many fields are getting pay raises less than inflation, imposing a drop in living standards. Congress shouldn’t have passed last year’s $1.9TN American Rescue Plan (ARP), and the Federal Reserve was at least a year late in shifting from its accommodative policy. These were two large mistakes. As a result, the Fed wants to drive unemployment higher, thereby pressuring real incomes. This is the consequence of the twin fiscal and monetary failures.

Pay that lags inflation requires workers to conclude no better alternative is available. There are signs of economic weakness. House prices are softening.  November’s auto sales figure of 14.6 million (seasonally adjusted, annualized) is recession-like, with 15-17 million more typical when the economy is growing. Recession forecasts are common, but the jobs market remains strong.

In April 2021, CPI registered 4.2% year-on-year, just when Congress passed the ARP and checks started going out to tens of millions of Americans. We’re close to two years of above target inflation. It’ll increasingly figure in wage negotiations until there’s more slack in the labor market.

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The Employment Cost Index (ECI) is rising at 5%, but adjusted for inflation is –2.9%. Year-end pay reviews are the norm across corporate America. For the vast majority of people who have held their current job for at least the last year, first quarter pay raises are common.

The ECI is seasonally adjusted, but the adjustment factors may be inadequate this time because annual raises will likely be bigger than usual. There are signs this is already happening. For several years the March ECI report has been above the trailing 4Q average. This bias has become more noticeable in the last two years. The seasonals haven’t caught up with higher annual pay raises to reflect increased inflation.

This suggests that wage inflation reported in the March ECI will be above trend and higher than the Fed would like. It’ll be published in April so is some way off – we’ll revisit this topic closer to the date. Some annual pay raises occur during the 4Q so will be picked up in January’s release, but so far there hasn’t been any visible anomaly in past releases of the December ECI.

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Last week the FOMC updated their Summary of Economic Projections (SEP). A more hawkish path for the Federal funds rate depressed stocks. The biggest discrepancy is with Dec ‘24 futures which yield 3%, 1% less than the SEP. The market thinks a recession is more likely than the Fed does, and therefore expects the Fed to cut rates next summer.

Inflation expectations remain well contained, which provides an exit ramp from tight policy anytime the FOMC wants to use it. But Fed chair Jay Powell doesn’t sound as if 4.6% unemployment (the SEP forecast for the end of next year) will be problematic. Economists debate what unemployment rate represents full employment. Its snappy title is the Non-Accelerating Inflation Rate of Unemployment (NAIRU). You only know where NAIRU is when falling unemployment causes inflation. Today’s 3.7% rate is well below it.

The St Louis Fed has a chart showing NAIRU at 4.4%. Some economists think it’s higher because of Covid-induced goods-inflation and reduced labor force participation. The Fed is unlikely to reduce rates until they’re sure the unemployment rate is above NAIRU, because they’ll be motivated to avoid yet another policy error. Once they start cutting rates, if inflation doesn’t keep falling, they’ll face no shortage of critics.

Jay Powell insists they’ll stay the course and maintain restrictive policy until inflation is clearly returning to 2%. When the blue dots on the SEP differ from the futures market, it’s usually resolved at the cost of the FOMC’s forecasting reputation. This time may be different.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The energy sector is closing out a strong year weakly. This shouldn’t detract from the fundamentals, which remain strong. The American Energy Independence Index (AEITR) is 36% ahead of the S&P500 YTD after finishing 10% ahead last year. That almost two-year period of outperformance is the best since the index’s inception date in 2010. Battle-hardened pipeline investors might fear a correction next year. It’s worth remembering what’s going right.

MLPs have outperformed the broader pipeline sector by 7% this year, recapturing a small portion of the past five years’ underperformance. Unfortunately, investors in the Alerian MLP ETF (AMLP) will miss out on over half of that because of a tax error (see AMLP Trips Up On Tax Complexity). Some MLPs are attractively priced, including Energy Transfer and Enterprise Products Partners, which both yield close to 8%.

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However, there aren’t enough MLPs to make up a diversified portfolio — one way to own the few that are worth the time is through a RIC-compliant fund that limits MLPs to less than 25% of assets. That avoids the tax drag faced by AMLP and other MLP-dedicated funds while still benefiting from the yield and shielding the investor from any K1s.

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US E&P companies are generating record amounts of cash. Examine the chart above carefully, because it shows each of this year’s quarterly pre-tax earnings and cash flow figures beating each of the full year results going back to 2014. E&P companies are having a great year every quarter! These are the pipeline sector’s customers. Profitability in the upstream segment is supportive for midstream, as this year’s results have shown.

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The chart showing gas-weighted E&Ps profitability converts into barrels of oil equivalent and shows that margin expansion is a big driver of profitability.

Factset projects S&P energy sector earnings growth of 150% this year, but that’s a broader universe than E&Ps and is dominated by majors such as Exxon Mobil and Chevron. Capital discipline continues for the most part – analysts expect TC Energy to sell some assets to fund its growing capex budget – but investor returns continue to dominate decision making.

Even though the White House’s chief energy adviser Amos Hochstein has accused investors of being “un-American” in not sharing the Administration ephemeral desire for increased output, investment returns are likely to reinforce capital parsimony.

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Domestic production of natural gas continues to set new records, and because it’s not a transportation fuel the pandemic had much less impact than it did for crude oil. The Energy Information Administration (EIA) is expecting record output next year.

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By contrast, jet fuel demand has still not fully recovered. Airfares in the CPI are up 43% over the past year, although they’re down 16% since the high in May.

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Countries with weather-dependent electricity such as the United Kingdom are enduring unusually cold and calm weather, which is reducing windmill output. London saw snow, which only happens about once a decade. UK wholesale power prices have spiked, but that will mostly be absorbed by the government since for now there are caps on consumer heating bills.

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The EIA produced an interesting pair of maps showing each state’s largest source of in-state power generation. The shift from coal to gas is easily seen, but there are three states (South Dakota, Iowa and Kansas) for whom wind power is number one. Personally, I don’t want to live in a state that relies on intermittent energy that takes up vast amounts of space, but some people are fine with it.

Asian demand for crude oil continues to grow. Morgan Stanley reported year-on-year increases of 10.2% in India and 12% in China – this being especially surprising given the widespread lockdowns that have been in place in China. There remains a strong underlying growth trend. Meanwhile Russian exports to Europe are down 80% on a year ago. It’s clear where those shipments unwanted by European buyers will be going.

There was an interesting report that linked the Keystone pipeline’s third spill in five years with increased operating pressure. US crude oil pipelines are limited to operating at a “yield strength” of 72% of maximum. In 2017 Transcanada, who owns and operates the Keystone, obtained approval to go to 80%. They will dispute circumstantial evidence that points to this increased pressure as the cause. Regulators are reviewing the data. Following the leak into the Kansas Mill Creek, the segment from Steele City, KS to the Cushing, OK storage terminal is closed.

Recent sector weakness belies strong underlying volume growth and increasing cash flow. Pipeline investors will have plenty to celebrate this Christmas.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

How do you conservatively value illiquid assets in a fund that offers liquidity to existing investors and accepts money from new ones? That’s the unsolvable question inadequately answered by the $125BN Blackstone Real Estate Investment Trust (BREIT), which is why they were forced to suspend withdrawals.

Private equity funds typically raise money and invest it over time. Generally, a fund’s investors commit at around the same time and share the portfolio results pro-rata. If a seasoned fund allowed latecomers who were enticed by early investment results, it would be unfair to those who committed at the outset without that information. In such a case, conservative low valuations on existing investments would harm the early investors whose stake in those positions would be diluted on unfavorable terms. High valuations might dissuade later investors if they felt they were paying too much for the existing positions.

It’s why successful private equity managers run one fund after another. It allows them to keep raising capital while ensuring each class of investors is pari passu. With realizations driving liquidity for investors and the manager’s incentive fee, interim valuations don’t matter that much.

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When it comes to illiquid assets such as real estate, a valuation range is more realistic than a single point. By allowing inflows and outflows, BREIT has sought to provide liquidity at odds with their underlying assets.  Smooth monthly returns, the promise of “consistent, tax-advantaged distributions” and the Blackstone brand made BREIT attractive to institutions. Their published monthly returns go to two decimal places, suggesting a precision at odds with what they own. They’ve reported three down months out of 69. Such unerring profitability should draw skepticism.

The fall in price of other publicly traded REITs has challenged the credibility of Blackstone’s valuation of the BREIT portfolio. The Vanguard Real Estate Index Fund (VNQ) was down 26% for the year through October. BREIT reports it is up 8.5% over the same period (they report with a lag). Some investors doubt that such a large fund could so nimbly avoid the markdowns that public market investors have endured. The biggest REITs in VNQ have seen their Price/Book ratio drop by over a quarter this year, suggesting book value for other funds will eventually be marked down.

BREIT addresses this, noting that they’ve sold $5BN of real estate this year “at a meaningful premium to carrying values.” They argue that because public real estate is only 8% of the market, private market values are more representative. Therefore, Blackstone regards today’s publicly traded real estate as being discounted to private market values rather than their own portfolio of private investments being overvalued.

Nonetheless, the BREIT investors who have exited recently and others blocked from doing so deem it attractive to redeem at an unchanged Price/Book.

Non-traded REITs, which are registered so as to have the widest possible set of buyers but unlisted to discourage analyst coverage, attract the ethically challenged as fund managers. Almost a decade ago we published Inland American Realty Runs Its Own Hotel California, concluding that disclosing how many ways you intend to fleece your investors can provide some defense when the SEC takes a close look. Non-traded REITs don’t perform regular appraisals, which has led their promoters to disingenuously extoll the consequent “absence of public market volatility.” For more, see Unlisted, Registered REITs; an Investment Designed for Brokers, and also chapter one of my 2015 book Wall Street Potholes.

BREIT shares some of the ignominious qualities of the maligned and shrunken non-traded REIT sector, although they prudently omit claims of low volatility or a high Sharpe Ratio that smooth monthly performance suggests.

Years ago as a hedge fund investor I ran into this problem with a convertible bond arbitrage fund (for the full story see The Hedge Fund Mirage Pp 107-111). If a fund’s bonds are priced by market makers at 101-102, they can be valued anywhere within that one-point range without the manager being open to accusations of misvaluation. If inflows are expected it can make sense to value at 102, pushing up the NAV at which new money comes in and helping performance.

Similarly, outflows might induce valuation at 101, benefiting remaining investors over those exiting. Since the manager must buy or sell bonds in response to flows, incurring transactions costs for the fund, this will always create winners and losers. Investors generally assume greater liquidity than really exists, and don’t consider transactions costs. Fund managers rarely educate them.

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The less liquid the assets, the bigger the range of valuations. Real estate doesn’t belong in a fund that allows regular investor flows. BREIT’s NAV sweeps majestically higher, impervious to the carnage afflicting all markets other than energy. But investors in Blackstone’s stock (BX) see a closer relationship with public real estate values as measured by VNQ rather than the private valuations represented by BREIT. Blackstone created the appearance of public market liquidity for privately held assets and asserts valuations remain strong. Their bluff is being called.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Dinner in late 2017 with Enlink’s soon to be CEO Mike Garberding and his management team was the most expensive I’ve ever had. Not because I had to pick up the check – they were gracious hosts. But because I left the restaurant impressed with Garberding’s grasp of the company’s opportunities and knowledge of the business. The result was we stayed invested in Enlink during Garberding’s time as CEO from January 2018 to August 2019, when it lost half its value.

Sometimes a careful, dispassionate analysis of a company’s SEC filings can tell you everything you need to know. Calls with management can improve your understanding but can also color your judgment. Eventually former CEO Barry Davis was pulled out of retirement to right the ship.

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That was five years ago, and today Enlink is a different story. CEO Barry Davis retired (again) in the summer and was replaced by Jesse Arenivas who joined from Kinder Morgan where he ran their CO2 division. Enhanced Oil Recovery (EOR) used to be the energy sector’s main use for CO2, pumping it into mature oil wells to force out more crude oil. If the CO2 is permanently sequestered underground, it even earns a tax credit under Section 45Q of the tax code..

The recently passed Inflation Reduction Act (IRA)  raised this credit to $60 per Metric Tonne (MT). Tax credits for producing crude oil may strike some as not consistent with reducing emissions, but the 45Q credits are turning out to be an important tool. The IRA raised the credit for CO2 captured from industrial processes to $85. Capturing CO2 from the ambient air (Direct Air Capture), where it’s 0.04% can earn up to $180 per MT.

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Under its new CEO Enlink is positioning itself as a key player in carbon capture. Their 4,000 mile natural gas pipeline network in southern Louisiana supplies the majority of industrial emitters in the region. In October they announced an emissions reduction agreement with CF Industries and Exxon Mobil to capture 2 million MTs pa of CO2. CF Industries is a major producer of ammonia, the key input for which is natural gas. CO2 is a byproduct of this process. Enlink estimates the potential could be as much as 80 million MTs pa, over 1% of total US greenhouse gas emissions. CEO Arenivas said Enlink is aiming to be, “…the transporter of choice for carbon in Louisiana.”

Commodities typically flow from upstream companies (such as Exxon Mobil) via midstream (ie Enlink) to downstream customers like CF Industries. There’s an interesting symmetry in the agreement in that CF Industries will send the CO2 it generates through Enlink’s pipeline network back to the upstream companies who are best placed to understand which geological formations are suited for storage. The carbon is being returned to its point of origin. It left as CH4 (methane, or natural gas) and is returning as CO2.

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Since the agreement was announced on October 12^th, Enlink has outperformed the American Energy Independence Index (AEITR) where it was a 2.37% weight at the last rebalancing on September 30. Midstream energy infrastructure companies are developing an important role in reducing CO2 emissions. For years climate extremists have opposed new pipeline construction thereby driving up free cash flow. Remember to hug a climate protester and offer them a ride. They’re vital to putting the CO2 underground.

Last week Enbridge and Occidental announced plans to develop a CO2 pipeline and sequestration hub near Corpus Christi in Texas. Occidental will handle the CO2 storage and Enbridge the transportation, in another example of reversing the traditional direction in which the commodity flows. When it comes to carbon capture, upstream is the new downstream.

Carbon capture is a twofold benefit for pipeline companies. Reducing the CO2 released into the air by petrochemical facilities demonstrates that natural gas consumption is not living on borrowed time, and the subsequent carbon capture offers a new revenue source.

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Meanwhile Europe is ramping up its capacity to import LNG. By 2024 they should be able to regassify 6.8 Billion Cubic Feet per Day, up by a third since 2021. Most of this additional capacity relies on floating storage and regassification units which can be operational more quickly than permanent, land-based facilities although they’re typically smaller as well. Poland is expanding capacity at an existing import terminal in the northwest. Within a couple of years there will be substantially more LNG tanker traffic through the North Sea and into the Baltic.

Until now Germany has never imported LNG, relying instead on natural gas from Russia via pipeline. Their energy policy is confused – long term goals to substantially reduce fossil fuel consumption remain in place, although they did recently sign a 15 year LNG deal with Qatar. They’re also contracting with trading house Trafigura to supply gas.

Enlink’s role in carbon capture is likely to be copied by other pipeline companies with similar infrastructure. This time we have no dinner plans with the management team.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

We all know the US tax code is complicated. ALPS Advisors, manager of the Alerian MLP ETF (AMLP), has been tripped up by the tax complexities inherent in their fund structure. As a result they’ve been forced to make an embarrassing NAV adjustment to AMLP for taxes, depressing the fund’s NAV by almost 4%. It must be frustrating for recent buyers, since it shifted the fund to a 2.7% monthly loss, 3.9% behind its index.

AMLP is that rare ‘40 Act fund that pays corporate tax. Under the 1940 Investment Company Act, mutual funds and ETFs, which are corporations, can qualify to be RICs (Regulated Investment Companies) and therefore be exempt from corporate tax if they meet certain rules. These include being fully invested in securities, meeting certain diversification thresholds and so on. Almost all such funds qualify. Investing more than 25% of your assets in Master Limited Partnerships (MLPs) fails the test to be a RIC.

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AMLP holds MLPs because in 2010 when it was launched, midstream energy infrastructure businesses were mostly MLPs, not corporations. AMLP provides a way for retail investors who don’t want K1s to invest in MLPs – but at the cost of lower returns because AMLP first pays corporate taxes on its realized returns before making distributions to its investors. We’ve written about this in the past (see  AMLP’s Tax Bondage and Uncle Sam Helps You Short AMLP).

An MLP-dedicated portfolio is out of touch with today’s sector, since many MLPs have converted to be corporations. The pool of money willing to invest directly in MLPs is limited to K1-tolerant US taxpayers – older, wealthy Americans. US equities are overwhelmingly held by institutions such as pension funds, endowments, foundations and sovereign wealth funds. These investors are mostly exempt from US taxes, so they avoid MLPs because it would create a tax liability for them. Only two of the ten biggest North American pipeline businesses are MLPs – the rest are corporations.

Several years ago the Federal Energy Regulatory Commission (FERC) announced a change in how their expenses were calculated that was adverse to natural gas pipeline MLPs. Taxes owed by their investors used to be included in the operating costs on which MLPs based their tariffs. FERC’s new rule would have lowered revenues, so natural gas pipelines soon converted to corporations to sidestep the issue.

It’s another example of the tax complexity that comes with MLPs. Although FERC later modified their stance, today’s MLPs tend to be (i) more liquids/less natural gas oriented, (ii) smaller, and (iii) more levered. The pipeline sector and MLPs are no longer synonymous.

AMLP has stuck with MLPs despite their shrinking relevance. If they considered diversifying into corporations this would put downward pressure on their current holdings, depressing their NAV and alarming investors. They’d need to obtain shareholder approval for this change of strategy and doing so would signal to the market an impending seller of MLPs. Many investors use AMLP to achieve pipeline exposure and, in our experience, few consider either the dwindling number of MLPs or the tax drag on returns. If AMLP was created today it would include pipeline corporations, in order to reflect the entire industry. It is an anachronism.

It now appears that AMLP investors must consider tax uncertainty on top of the haircut this imposes on returns. In their press release ALPS Advisors blames the NAV reduction on tax legislation passed in 2017, as well as the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), which was passed in March 2020. The problem is not recent.

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AMLP’s tax liability is updated daily, which suggests some certainty around its calculation. It looks as if ALPS had to modify their interpretation of the tax code, resulting in the sudden 3.9% NAV reduction. It must be complicated. Going forward, investors can no longer rely on the published tax liability. The press release warns that, “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, if ALPS gets their tax math wrong again, investors might face another big NAV adjustment. Because AMLP is a tax-paying entity and the tax code is fiendishly complicated, you can’t rely on the NAV being accurate.

Over the past five years, AMLP has significantly lagged the midstream energy infrastructure sector, because MLPs have lagged corporations and been more likely to cut their distributions. Investor inertia has presented little reason for any changes but lagging performance and now uncertain tax expense leave little here for the discerning investor.

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Midstream is up 27% for the year as of Tuesday, but investors are showing no irrational exuberance. The North American pipeline sector retains its MLP moniker because MLPs used to be the dominant business structure. Even though it’s now two thirds corporations, the ‘40 Act funds who specialize in the sector are still called MLP funds.

Investors have been exiting MLP funds for several years. JP Morgan calculates that 2016 was the last calendar year that saw inflows. The shale bust led to distribution cuts and saw several big MLPs convert to corporations. They did this in search of a broader investor base but often created a poor tax outcome for their MLP holders. The archetypal K-1 tolerant, US taxable, income seeking investor (ie rich old American) left in disgust. The Covid collapse in March 2020 was, for some, the last straw.

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Fund flows are a notoriously poor predictor of performance. Look at the ARK Innovation ETF, where inflows were synchronized with its peak in early 2021. Within a year it had achieved the ignominy of earning a negative return on the average dollar invested (see ARKK’s Investors Have In Aggregate Lost Money).

The history of MLP fund outflows coincides with a generally declining Alerian MLP Index (AMZ), but that is misleading because AMZ omits pipeline corporations which are held by the more diversified funds. Since September 2018 (the beginning of the fund flow chart) the broad and therefore more representative American Energy Independence Index (AEITR) has returned 10.8% pa.

The fundamentally bullish case for the sector is familiar to regular readers. However, the positive return despite persistent retail selling of MLP funds is another reason for optimism. If prices are rising when investors are turning away, it suggests that even a cessation of outflows could provide a further boost.

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Morgan Stanley calculates that for the first nine months of this year midstream companies repurchased over $3.1BN in stock. This more than offset the selling of MLP funds by retail investors. What could be more bullish than the less informed selling to the better informed?

Investors like the link to PPI inherent in pipeline tariffs. It allows the companies to raise prices in line with inflation, expectations for which have remained surprisingly quiescent. The ten year CPI implied by treasury yields minus TIPs is a remarkable 2.28%. Since the next year will be well over the Fed’s 2% target, investors seem very comfortable that inflation will be back at pre-pandemic levels soon after. The University of Michigan survey provides a slightly different view, with CPI for the year ahead expected to be 5% and 2.9% over the long run.

More consumers report hearing about inflation hurting business conditions, and 43% report that rising prices are eroding their own living standards, up from 20% a year ago. John Williams, president of the Federal Reserve Bank of New York, warned that the unemployment rate could reach 5% as the Fed cools the economy, which would mean around 2.5 million extra unemployed.

With the unemployment rate at 3.7% and inflation just under 8%, the Employment Cost Index (ECI) is rising at 5%. This still leaves many workers worse off in real terms. Greater awareness of inflation as shown in the Michigan survey suggests it will figure more in pay demands as well as spending patterns where half of consumers report cutting back.

Four railroad unions have rejected a 24% pay increase over four years, threatening a strike that could cripple the movement of freight across the US. Congress may force them back to work. The US has a history of legislating against the disruption caused by strikes. In 2005 the New York City transit system shut down for a couple of days over a pay dispute. Under the law, the union leader was sentenced to ten days in prison and the union fined $2.5 million. Workers can strike but not if it causes substantial economic harm, which seems right.

By contrast, in the UK workers on the London underground schedule one day strikes every couple of weeks. An email update sent to travelers in early November breezily advised that there are “lots of public transport options” but added, “There are also some planned strikes taking place over the weekend and into next week.”  There is no equivalent legislation that prevents a small group from inconveniencing millions, a significant omission from UK labor law reflecting the country’s liberal leanings.

It’s one reason why UK inflation tends to run higher than in the US.

Upcoming ECI releases will be interesting because pay raises tend to come around year end. Consequently, the December and March ECI seasonal adjustments correct for this and lower the index. The seasonal factors are based on pay increases in a world of 2% inflation. With pay raises running at 5% and the job market robust, it would seem that the ECI could reflect higher than normal pay raises because the seasonal adjustments will be inadequate. Inflation will appear more entrenched, requiring a higher rate cycle peak.

The December ECI is some way off – the September report will be released on December 15^th. Inflation won’t return to 2% until workers accept reduced compensation. There’s plenty of reasons to think this won’t happen soon.

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