Searching for Christmas

Our blog has a Search function that allows users to quickly find what they’re looking for. One of our most often read blog posts is MLP Funds Made for Uncle Sam, which is easily found by entering “Sam” in the search box.

SL Advisors is a secular organization, but searching for the word “Christmas” generates a surprising number of results.

Some relate to the seasonal pattern in which November weakness in MLPs is followed by a rally into January. Why MLPs Make a Great Christmas Present, MLPs Lose That Christmas Spirit and MLPs Weak in November, As Usual all reference Christmas in the text.

In Stocks Are the Cheapest Since 2012 a year ago we welcomed Christmas as a respite from relentless selling. Stocks, including midstream energy infrastructure, duly rallied with our American Energy Independence Index gaining 20% since then.

Investor frustration with the sector was high at times during 2019, and few probably expected the year’s returns to finish where they are. Energy infrastructure has joined the festive season in recent weeks.

Although New Jersey is not having a white Christmas, it’s still too cold for golf. This remains one of our favorite cartoons.

We wish all of our readers a Merry Christmas, Happy Holidays, and much joyful time with family and friends.

Pipeline Bond Investors Are More Bullish Than Equity Buyers

One of the most consistent bullish indicators for stocks has been the Equity Risk Premium (ERP) – the spread between the earnings yield on the S&P500 and the ten year treasury yield. At the end of last year, the S&P500’s 2019 earnings yield was around 7.2% (one divided the P/E ratio, which was then 13.8). With ten year treasuries at 2.8%, the ERP was 4.4, well above the 50-year average of 0.6.

The S&P500 is up 30% this year, and the P/E multiple has expanded to 18X next year’s  earnings (i.e. earnings yield of 5.5%). This has brought the ERP down to 3.6 — still favoring stocks, but not as clearly as a year ago. If treasury yields had remained at last year’s levels rather than dropping almost 1%, the ERP would be even lower at 2.7.

Since stocks look cheap, bonds must be expensive. Perhaps the biggest unanswered question facing investors today is why long term bond yields remain so low, and whether this is sustainable.

The return bond investors require over inflation, the real rate, has been in secular decline for thirty years (see Real Returns On Bonds Are Gone). Today’s bond investors are willingly locking in low and negative real yields – in many cases even negative nominal yields. Two compelling explanations are (1) inflexible investment mandates, and (2) fear of another 2008 financial crisis.

U.S. pension funds have raised their fixed income allocation even while yields have fallen, a counter-intuitive response to lower expected returns (see Pension Funds Keep Interest Rates Low). Hard evidence that investors are holding additional low risk assets as protection against a crash is harder to come by, but low yields certainly support that explanation.

Lower real yields on sovereign debt are a result of investors’ strong desire for bonds with negligible credit risk. But the fact that corporate bond yields are being pulled down by these same forces reveals a pricing inefficiency that equity investors can exploit.

It’s most clear at the individual issuer level, where excessive demand for debt instruments is causing some interesting distortions. The table shows long term bond yields for the ten biggest North American pipeline companies, with an average equity market capitalization of $39BN.

They’re all members of the American Energy Independence Index, the broadest and most representative index of North American midstream energy infrastructure. These ten companies have outstanding bonds with maturities of 25-40 years. They are all investment grade, offering an average yield of 4.3%, which reflects a high degree of comfort with their credit risk over several decades.

By contrast, their equity dividend yields average 5.8%, 1.5% above their bond yields. And this even includes Cheniere Energy (LNG), which doesn’t currently pay a dividend (although they’re likely to institute one over the next couple of years).

Energy has been out of favor more or less since 2014, although stock price performance in December has been strong. These ten companies’ average dividend yield is almost 3X the 1.75% yield on the S&P500, reflecting substantial wariness about their prospects. And yet, bond investors don’t share the same concern.

Equity investors can earn higher yields than bond investors on the same issuer, in addition to enjoying likely earnings and dividend growth in the years ahead. Once equity prices reflect the positive outlook reflected in their long term debt, they’ll re-price higher.

Based on recent performance, that revaluation may already be under way.

We are invested in all the names mentioned above.

Stop Flaring

Tallgrass Investors Catch a Break

Yesterday Blackstone (BX) surprised Tallgrass Equity (TGE) investors by sweetening their offer for the shares they don’t own to match the price they originally paid in March. It marks a victory for Limited Partners in TGE, which retained its partnership structure even though it’s taxed at a corporation so as to avoid issuing K-1s.

The sideletter that provided a floor on the price management received for their LP units was unfair, and caused us to criticize it in September (see Blackstone and Tallgrass Further Discredit the MLP Model) when BX announced their offer to acquire the remainder of the shares. Most sell-side analysts were embarrassingly silent in standing up for their investors, conflicted as they are by the desire to win banking mandates from the protagonists. RW Baird’s Ethan Bellamy is a standout exception, unafraid to raise awkward questions during earnings calls, which renders his research opinions more credible. Other sell-side analysts should take note.

TGE CEO David Dehaemers claimed not to understand (see Tallgrass Responds to Critics, Missing the Point) and with nobody else publicly taking his side, he brought forward his retirement. This ended a disappointing episode in an otherwise successful career.

Although the degree of sweetening from BX was a surprise, once they’d invested in TGE it always made sense for them to acquire the rest. Having a public equity position in a private equity portfolio adds unwelcome valuation realism. Private equity funds are reporting far better investment returns than public markets (see Private Equity, Private Valuations), even though they occasionally commit some howlers (see Leverage Wipes Out Investor’s Bet on Enlink). GIP’s 44% partial ownership of Enlink (ENLC) can hardly be their desired position – they’ll either buy the rest or exit, realizing a substantial loss. Information on GIP’s intentions has been sparse. PE investments rarely lose value as quickly as this one, and explaining it has been an unwelcome distraction for GIP’s overworked investor relations people.

TGE’s pending disappearance as a public company also represents another step in the shrinking universe available to Alerian’s MLP indices. TGE was a 4.7% weight in the Alerian MLP and Infrastructure Index (AMZI), followed by the tax-burdened ETF AMLP (see MLP Funds Made for Uncle Sam). TGE is far less than 4.7% of North American midstream energy infrastructure, as shown by its 2.4% weight in the American Energy Independence Index. Because AMZI is limited to partnerships, the TGE proceeds will have to be reallocated across a subset of the pipeline sector, further increasing AMLP’s concentration and rendering it even less representative (see AMLP’s Shrinking Investor Base).

Private Equity, Private Valuations

Last week Cowen held a two day energy conference. Presenting companies included upstream and service providers, so although there were no midstream energy infrastructure companies present it provided useful background for current operating conditions.

Baker Hughes (BKR) is one of three large diversified services companies supporting the sector, along with Schlumberger and Halliburton. BKR CFO Brian Worrell provided an upbeat outlook following their recent spinout from GE. They cleverly describe themselves as a “fullstream” company (i.e., covering upstream to downstream). Listening to Worrell, it’d be hard to remember how negative investor sentiment is within energy. Consensus estimates for BKR’s 2019-21 EBITDA growth rate are 15%.

Worrell provided some interesting background on a partnership they have with AI firm C3. Predictive Asset Maintenance, one of their offerings, analyzes operating data from customer equipment to anticipate breakdowns, allowing repairs to be done pre-emptively. BKR is C3’s exclusive partner in the energy sector. They have 200 customers.

Another interesting theme was the influence of Private Equity (PE) investors. Independence Contract Drilling (ICD) is a micro-cap drilling company clearly wrestling with the downturn in shale-related rig demand. One participant asked if they’d considered a sale or merger. President and CEO Anthony Gallegos noted a recent negotiation with a competing privately owned firm which foundered when the PE backer insisted their drilling rigs were worth $18MM each while ICD’s stock price placed an implicit value of only $6MM for its similar equipment.

There’s plenty of evidence that PE firms assess more value in publicly traded energy sector equities than the public markets themselves. PE investments in midstream energy infrastructure have slowed down in recent months, although it’s still been an active year. But there are questions about valuation.

Energy-focused PE funds saw their highest inflows in 2014, when the sector peaked. This isn’t surprising, since fund flows invariably follow performance. But what’s odd is that fund returns since then are well ahead of the S&P600 Energy Index.

Although PE funds deploy capital over several years and likely made investments through the 2016 low, the recovery since then has been modest. It suggests that valuations are not rigorous – PE firms have a great deal of latitude in making estimates. Fees and the ability to raise subsequent funds both benefit from higher valuations.

PE energy funds continue to raise capital, supported in part by the returns they show on prior funds. The illiquidity of private investments is supposed to generate a modest return premium, but research from Cobalt GP reveals that so far these funds are claiming to beat public markets by 15-30%. Total Value to Paid In (TVPI) suggests these fund managers have chosen well, and is the basis for their IRRs. But Distributions to Paid In (DPI) are well under 1.0X even for funds that are five years old, showing that the IRRs rely heavily on the valuations of current holdings. As cash distributions increase, the time of reckoning will arrive when investors will learn how accurate these interim IRRs have been.

On a different topic, the magazine cover contrary indicator theory posits that when a topic or person becomes mainstream, interest soon peaks. Credit friend Barry Knapp, CEO and founder of Ironsides Macroeconomics, for being first to predict that high school dropout Greta Thunberg’s selection as Time’s Person of the Year likely marks a peak in interest in climate change.

Enlink’s Growth Plans Need Better Justification

Energy investors would still like to see less spending on growth projects than company executives are pursuing. Whenever a CEO announces new spending, there’s a palpable lack of enthusiasm. Given valuations, many companies could easily justify buying back stock as a higher return use of capital than building new infrastructure. The message is getting through, but not quickly enough in the opinion of many.

Part of the problem is the way companies present their growth plans. A recent investor presentation from Enlink (ENLC) illustrates the problem. Their 2020 Growth Capital Expenditures (“capex”) are listed as $275-375MM. The collapse in ENLC’s stock price this year has driven their dividend yield up to 25%, a lofty level they plan to maintain. Since stock repurchased would therefore generate a 25% return as they claim DCF coverage >1X, it’s hard to believe they carried out a rigorous analysis on where they plan to invest cash that clearly won’t be used to buy back stock. Theoretically, their capex plans will yield a higher return that their stock, the implausibility of which casts further doubt on their capital allocation.

However, the problem with the presentation is the focus on EBITDA multiples to illustrate the attractiveness of their capital program. Over two thirds of their projects will generate an adjusted EBITDA multiple of <4X. In other words, $100 invested will generate better than $25 of EBITDA.

By coincidence, ENLC’s projects offer a return similar to their dividend yield, perhaps justifying them as a better use of scarce funds rather than buybacks. But over half the projects are for natural gas well connects, gathering and compression. These are not long distance transportation pipelines, but narrow lines running to individual wells. Their volumes will begin strongly and deplete as output from the wells they’re servicing depletes.

The point is that projects should be evaluated on an NPV basis, taking account of all the future cashflows. An EBITDA multiple is a shorthand way of comparing projects, and only makes sense when that EBITDA is stable or growing. ENLC’s CFO presumably doesn’t assess projects that way.

The types of project ENLC is planning have declining EBITDA. Including them in their presentation the way ENLC does creates a misleading impression of highly attractive investments. When we asked ENLC about the absence of any decline assumption in their own capex guidance, they referred us to Devon Energy’s (DVN) comments on the issue. DVN is the big customer whose production ENLC’s capex are intended to service. DVN has forecast production declines rates from “high 20% to high 30%”. DVN isn’t claiming that production will be stable. So why is ENLC using the first year’s cash flow to justify the capex in its presentation?

ENLC must know that presenting an investment based on the first year’s cashflow doesn’t fairly present the longer term outlook. They should either model the EBITDA over several years to show the decline rate they expect, or present the NPV analysis that they’ve presumably done internally before committing capital. A cynic might believe ENLC is doing projects with a negative NPV because the first year’s EBITDA flatters their leverage ratio, temporarily boosting EBITDA and thereby lowering Debt:EBITDA.

Energy companies are being criticized for poor capital allocation – a more transparent and rigorous explanation of spending would help ease investor concerns.

ENLC has plenty of room for improvement in this area. We hope they do. We are invested in ENLC and believe it’s cheap. The market is not giving energy management teams the benefit of the doubt and their stock would benefit from our suggested improvements in their presentation.

Williams Companies Promotes the Little Blue Flame

Last Thursday Williams Companies (WMB) held their investor day in New York. WMB owns and operates an extensive natural gas network, and is a top ten U.S. midstream energy infrastructure company. Like most big pipeline companies, it’s omitted from the Alerian MLP indices because it’s not an MLP. CEO Alan Armstrong conceded that the company had in recent years become too closely identified with the oil business and fracking. He said they need to refocus attention on the little blue flame in every kitchen’s stovetop, emphasizing a cleaner, more positive message.

Their presentation opened with some useful slides on the long term, global outlook for natural gas. Although most investors in this sector follow crude oil prices because they drive sentiment among energy investors, our investments are more focused on natural gas because it’s the cleanest burning fossil fuel and we believe has a clearer growth path over the next several decades.

The Shale Revolution has produced an abundance of natural gas in America, which means that it’s not only cleaner than other fossil fuels but also the cheapest form of residential heating. So far, the benefits of this abundance have flowed to the consumers of cheap energy and not the producers, as energy investors know well. Figuring out how to better monetize America’s energy renaissance consumes management teams and investors.

Substantial press coverage is focused on climate change and the opportunity of renewables to impede global warming. Solar and wind remain fringe sources of overall energy, a statement often regarded as incendiary by climate extremists but easily supported in the above chart. Electricity is 20% of global end-use energy consumption, with solar and wind providing 2% and 5% respectively. So at 7% of power generation, which is itself 20% of global energy use, they’re 1.4% of the total. Natural gas substitution for coal has been far more effective in lowering emissions, and attracts thoughtful advocates for cleaner energy.

An estimated 17,300 children younger than 15 die every day because of insufficient access to energy, according to UNICEF (the United Nations Children’s Fund). The moral high ground is solidly occupied by those engaged in providing more energy to poor countries, including investors in WMB. Climate extremists impede this progress, and offer no solutions. Their warped, Malthusian philosophy cares little for today’s human suffering.

Global energy consumption is going to continue increasing, because it drives higher living standards which are desired by at least half the world’s population. Non-OECD countries are forecast to increase their energy demand by half over the next twenty five years. Any serious impact on emissions will turn on the form in which this increased energy is delivered. China is the world’s biggest polluter and consumes half the world’s coal. If natural gas replaced all the world’s coal, it would lower CO2 emissions by 17%, an enormous change. The world isn’t about to make such a bold move, but because natural gas is expected to fulfill 45% of global demand growth through 2040, its gain in market share is contributing to a cleaner planet.

Finally, we show a slide on valuation. Valuation metrics such as Enterprise Value/EBITDA and yield have become less attractive for REITs and utilities in recent years, while they’ve moved in the opposite direction for midstream energy infrastructure. Investors know this well, but the macro outlook for natural gas must surely mean that a company such as WMB, positioned as well as anyone to profit, is cheap and should be substantially higher.

We are invested in WMB.

Why Inflation Isn’t What You Think

The Federal Reserve has long wrestled with stubbornly low inflation. A decade ago few would have expected this to be a problem, but Personal Consumer Expenditure (PCE) inflation, the Fed’s preferred measure, is coming in at 1.8% this year. Federal Open Market Committee (FOMC) members have been considering allowing inflation to overshoot their target of “around 2%”. As Eric Rosengren, president of the Federal Reserve Bank of Boston, noted, if you’re trying to average 2%, “you can’t have only observations that are below 2 per cent.”

One consequence is that, when inflation does eventually move above 2%, the FOMC may delay efforts to lower it so as to allow for some catch up.

Outside of the FOMC’s technical concern with achieving its desired 2% average, inflation generates few worries. Keeping up with the cost of living is a crucial objective of saving for retirement, yet few appreciate a shortcoming in traditional measures of inflation.

Inflation indices measure the cost of a representative basket of goods and services of constant utility. The basket rarely fits individuals, but it reflects society’s pattern of purchases and so is right on average. The catch is in the last phrase, of constant utility. Products and services generally improve, and because those improvements increase utility, statisticians typically adjust for the improvement, lowering inflation.

Consumer electronics is a good example. iphones get better and more expensive with every new release. But the inflation data place a value on those improvements and adjust down to calculate the price of an iphone with the same features. My niece took clear, well-lit photos on the weekend with her iphone 11. The phone costs more, but the photo quality means you’re getting more phone than before. Better photos mean more utility, although beyond the enjoyment of being flattered by the imagery, there’s little else to do with that extra utility.

The Bureau of Labor Statistics (BLS) publishes the Consumer Price Index (CPI). The Fed prefers the PCE because it dynamically adjusts for shifting consumption patterns, and is more representative of actual consumer behavior. But for decades we followed the CPI, and the point that follows applies to inflation indices generally.

The BLS publishes a list of items in their CPI subject to “hedonic quality adjustment”. It’s mostly clothing and consumer electronics. Mens’ suits are apparently improving in quality as well – or perhaps it’s now harder to buy a cheap suit. In any event, suits are apparently better value for money than in the past, which in inflation math is deflationary.

I wrote about this topic in Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. In a subsequent blog I highlighted one of the most absurd hedonic quality adjustments – airline tickets (see Why Flying is Getting More Expensive). Even though economy flyers everywhere would agree that cramped seats and lousy food make commercial air travel an endurance, the BLS found that quality (which they defined simply as ease of cancellation) had improved, boosting value for money and thereby lowering the cost of airfares within the index.

What it means is that keeping up with inflation doesn’t mean keeping up with your neighbors. The statisticians are measuring prices, and their approach has some logic. But they’re just not measuring what most of us think they’re measuring. If inflation seems lower than the rate you experience personally, it’s probably because you accept quality improvements but don’t think of them as price reductions. iphones cost more, even if hedonic quality adjustments provide an offset. You’re still having to pay more cash, leaving less for something else. Inflation statistics reflect this less than you think.

MLPs Weak in November, As Usual

The Alerian MLP Index now has almost a 24 year history. Investors whose experience pre-dates the 2014 high will fondly recall many strong years. Since 1996 the compounded annual return is 11.3% including distributions, even though the AMZX remains 44% off its August 2014 high.

MLPs are a shrinking part of the midstream energy infrastructure sector, and the AMZX omits many of North America’s biggest pipeline companies, because they’re corporations not MLPs. Flows in MLPs and related funds are still dominated by retail investors, which is why the January effect has historically been more impactful than is generally the case for the S&P500.

The human tendency to take stock of one’s portfolio around year’s end is exacerbated by the impact of K-1s. Sell an MLP in December rather than January, and you’ll avoid a K-1 for that one month of the new year. Similarly, a purchase delayed from December to January avoids a K-1 for the last month of the prior year. Both these effects tend to lift prices in January versus December.

Tax loss selling is another feature that tends to weigh later in the year. U.S. equities are owned in large part by institutions that are often tax exempt, so tax planning has a more muted effect on the broader market.

Consequently, MLPs exhibit the seasonal pattern shown in the chart above. It may be some comfort for investors to be reminded that November is historically the best time to make investments in the sector. You’ll also note a smaller pattern around quarterly distributions, which generally fall in the middle of the quarter. Investors tend to avoid selling when a new distribution is imminent, so returns in the first month of the quarter are usually above average. It ought to make no difference at all – stock prices adjust for dividends paid when they go ex-dividend. Nonetheless, the pattern further suggests that sales made in the first month of the quarter will on average draw a higher price.

January stands out as a very strong month, returning three times the monthly average.

In recent years familiar patterns have been less reliable, including the tendency for MLPs to outperform the equity market (yes, they used to do that). The seasonals of the past five years reveal a very different pattern. As the sector has slumped, a clear trend has emerged of investors selling during the fourth quarter. The first half of the year has remained stronger than the second half, although oddly April has been better than January. Perhaps planned January purchases have been delayed because of prior weakness.

So far, October and November are continuing the pattern of 4Q weakness seen in recent years. We know anecdotally that tax loss selling has been a factor for some investors. It still looks to us as if a bounce in the early part of the new year remains likely. Sentiment is certainly consistent with current prices providing a near term low.

MLP seasonals remain interesting because of what they tell us about past retail investor behavior. Nonetheless, the MLP sector remains too small with too few well managed companies to justify a significant allocation. The American Energy Independence Index is 80% corporations with just a handful of MLPs. It’s +13% YTD compared with -5% for AMZX, starkly illustrating the preference investors have for pipeline corporations over MLPs, and the steady exit of retail investors from MLP-dominated products. Note that you cannot invest directly in an index.

We manage an ETF which seeks to track the American Energy Independence Index.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund. To learn more about the Fund, please click here.

Tallgrass Endgame Approaches

Most sell-side analysts are constrained in providing critical analysis of the companies they cover, because their firms are usually trying to do investment banking business with them. In spite of all the regulations intended to create a separation between research and banking, typically less than 10% of analyst ratings are a sell (see Why Wall Street analysts almost never put ‘sell’ ratings on stocks they cover).

Blackstone (BX) and Tallgrass (TGE) recent showed how a publicly traded partnership can promote management’s interests at the expense of other investors (see Blackstone and Tallgrass Further Discredit the MLP Model). Few were openly critical, because it conflicts with their business model. R. W. Baird’s Ethan Bellamy is one of the few whose integrity isn’t for sale. Morningstar’s Stephen Ellis spoke plainly because his company doesn’t offer banking services. Others obliquely referred to the controversial sideletter. To recap, BX acquired 44% of TGE earlier this year. If BX agreed to buy the rest of TGE within a year, a sideletter guaranteed TGE management a fixed price for their LP units, thus breaking the alignment of interests between owners and management. As TGE sank during the summer, the odds of BX seeking the rest rose. A weak stock price for TGE made the sideletter more valuable. It looked like a put option.

On Monday, David Dehaemers announced his imminent retirement from Tallgrass, where he did much right as founder and CEO. The eastbound Rockies Express natural gas had seemingly little future with new Marcellus natural gas competing for midwest customers. He oversaw a partial flow reversal, cleverly adapting to new patters of supply. The sideletter and his tone-deaf defense of it were a disappointing departure from his normal straight talk. It caused us to ask of other pipeline companies organized as partnerships how we might get comfortable that they wouldn’t also “do a Tallgrass”. It caused us to ask ourselves, and to question publicly, why we as asset managers should invest in companies whose ethical standards fall so far below those imposed on us by regulation and good practice.

There are some well-run companies in this sector. The three big Canadians (Enbridge (ENB), Pembina (PBA) and TC Energy (TRP)) are shining examples of investor-oriented, prudent management. Most U.S. pipeline companies would be better investments if they were run like Canada’s (see Canadian Pipelines Lead The Way). Enterprise Products Partners (EPD) and Magellan Midstream (MMP) are among the better run American companies. Crestwood (CEQP) in recent years has been well led by Bob Phillips.

It’s likely the investor outcry over the TGE sideletter hastened Dehaemers’ retirement, although he had indicated he was likely to leave by the end of this year. On TGE’s most recent earnings call, he blamed selling institutions for weakening TGE such that BX was induced to offer to buy the rest of TGE at below their original purchase price. It was as if he blamed the selling for embarrassing him by drawing attention to the sideletter, although this document was working as designed in protecting him from TGE’s downside.

It’s unclear what this tells us about the likelihood of TGE accepting BX’s proposal. TGE trades 7% below BX’s $19.50 offer, which was made three months ago. We helped highlight the unfair sideletter’s bias towards management. If ultimately BX buys the rest of TGE at a fair price without the special provisions for management, that will be a win for plain speaking. Not that long ago, David Dehaemers would have agreed.

We have only a minor investment in TGE