In recent weeks, 2021 natural gas have been quietly moving higher. November ’21 futures have rallied over 40 cents, to just under $3 per Thousand Cubic Feet (MCF).

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Covid and the election are both behind this. Research reports from Goldman Sachs and Morgan Stanley both explore energy markets through the pandemic and likely policy changes if Democrats win next month.

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Associated gas that is produced along with crude oil in the Permian in west Texas has long weighed on prices. This gas wasn’t needed – because it had so little value, some of it was flared. The Texas Rail Road Commission (RRC) never rejected a flaring application, causing critics to ask why they regulated it at all (watch Stop Flaring).

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The collapse in oil demand in the Spring led to production cutbacks in the Permian, which also reduced the volume of associated gas. Morgan Stanley notes that falling prices had already been reducing the gas rig count in key producing areas prior to Covid, and this trend accelerated during the spring. Domestic gas production is increasingly driven by the economics of the gas market.

The election has had a more recent impact. With Joe Biden retaining his lead in opinion polls, markets are beginning to price in a Democrat victory, including the possibility of taking control of the Senate. VP candidate Kamala Harris pledged that a Biden administration would not ban fracking – a predictable pivot away from the anti-fracking posture Biden adopted during the primary.

Some of the more sweeping moves against the domestic energy business associated with the Democrat platform would require acts of Congress. This includes banning fracking on private land. Another example would be tightening the standards around produced water, since the 2005 Energy Policy Act excluded fracking from the Safe Drinking Water Act. It’ll be hard persuading senators from either party in oil-producing states to support legislation that’s harmful to their voters.

However, Goldman notes that a Biden presidency could restrict drilling on Federal land, clamp down on methane emissions and use other regulatory tools to increase the cost of production. Democrat policies are designed to produce higher energy prices, since this improves the competitiveness of renewables (Listen to Joe Biden and Energy and read Why Exxon Mobil Investors Might Like Biden).

A new administration might also engage more with Iran. Goldman notes that the return of 1 million barrels per day or Iranian output to oil markets would restrain Permian crude production and keep a lid on associated gas. It’s not intuitive, but diplomatic engagement with Iran is bullish for natural gas prices.

Will this be good for pipeline stocks? Trump pursuit of energy-friendly policies has led the industry into an exuberant glut of production. It’s not his fault, but it’s led to poor investment returns. Rising natural gas prices could be a sign of more parsimonious capital allocation. If pipeline stocks follow energy prices up the same way they’ve followed them down, few investors will complain.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The energy sector has long been criticized for reinvesting too much capital back into its business, without ensuring that such investments exceed their cost of capital. No business can survive unless its return on investments is more than the cost of financing them.

Equitrans Midstream Corporation (ETRN) has an opportunity to demonstrate that they understand this.

ETRN’s major initiative is the Mountain Valley Pipeline (MVP) project, a natural gas pipeline with 2 Billion Cubic Feet per Day (BCF/D) of capacity connecting the Marcellus shale in West Virginia with customers in southern Virginia. Environmental extremists have been using the courts to block MVP for years, but ETRN management remains confident in its ultimate completion — albeit less so on the timing.

The first stage of the project, including feeder systems Hammerhead and the Equitrans Expansion Project, is expected to cost $3.4BN and generate $320MM in EBITDA. So the initial investment has a cash-on-cash return of 9.4%, well below the company’s target of a mid-teens IRR.

ETRN management believes they could add another 0.5 BCF/D of capacity for just $200MM. This would generate an additional $65-70MM in EBITDA, a whopping 33.7% Return On Invested Capital (ROIC). Expansion projects often have high returns, since they leverage off existing infrastructure and face less uncertainty.

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The expanded MVP should generate $385-90MM on $3.6BN of capital, a 10.7% return. ETRN clearly needs to complete MVP – most of the capital has already been deployed. And the expansion, with its 33.7% ROIC, is an easy decision. But how should they think about allocating capital in the future, once this project is done?

Currently, ETRN generates EBITDA of around 1.2BN. Following MVP’s completion, this will increase to $1,587MM, which we’ll round up to $1.6BN. A reasonable estimate of the sustainable cash flow to the owners is to start by deducting interest expense ($300MM on $6.4BN of debt) and taxes (which are currently zero as depreciation charges offset its taxable income). The company spends $75MM on maintenance capex, which is generally intended to offset depreciation and amortization, both of which are non-cash expenses. So the company will be generating $1,225MM for its owners.

ETRN’s 432 million shares at $8.60 give it a market capitalization of just over $3.7BN. Its cost of equity is therefore 33%.

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A company is supposed to invest so that its ROIC is more than its Weighted Average Cost of Capital (WACC). In this case, assuming ETRN finances its assets with 50% debt which costs 4.7%, its WACC is 18.85%. Any project that fails to earn a return above this WACC is destroying value for the owners.

The disconnect between ETRN’s cost of equity and debt isn’t unique to them – it’s common across midstream energy infrastructure. Enterprise Products Partners (EPD) common units pay over a 10% dividend and trade at a 17% distributable cash flow yield, while it has 30 year debt outstanding yielding  under 4% (see Tech Stocks Have Energy). Stock and bond investors hold sharply different views on pipeline stocks.

When EPD canceled an $800MM investment in a crude oil pipeline recently, the stock rose because this meant more cash for buybacks (see Investors Like Less Spending).

What it means is that ETRN should consider buying back equity as a use of capital competing with any other investment they might consider. Although the MVP expansion offers an ROIC comparable to the company’s cost of equity, they don’t have any other projects that come close to earning that type of return. In fact, the company has indicated they are seeking a mid-teens internal rate of return on new projects, so they’re not even trying to beat their WACC.

This makes no sense, based on ETRN’s stock price. Too many companies regard growth projects as an unassailable part of their business, almost a raison d’etre. They have a culture of always building. It’s because they’ve ignored this type of math that pipeline stock prices are so low.

Once MVP is finished, ETRN will demonstrate their grasp of corporate finance based on whether they recognize that buying back their stock is the best use they can make of their cashflow. If instead, they pursue the next growth project with a projected return half their cost of equity and even below their WACC, they’ll be confirming their financial innumeracy.

Too many midstream CFOs find grasping their cost of equity an elusive concept. If the components of WACC were reversed such that the cost of debt was 32%, few projects would be more attractive than paying down debt.

The distortion in capital markets between debt and equity should compel the entire midstream sector to reassess how they deploy their free cash flow, which is set to grow substantially (see Pipeline Cash Flows Will Still Double This Year).

Even Targa Resources, a company with a long history of flunking the math of capital allocation (see Pipeline Buybacks and ESG Flexibility), recently surprised many by correctly initiating a buyback. As others follow, the boost to their stock prices will be substantial.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Targa Resources, a perennial mis-allocator of capital, is not an obvious candidate to initiate a buyback program. Nonetheless they did on Monday, and the stock rose almost 11% on the news. In February last year, when Joe Bob Perkins was CEO, he responded to questions about their capex plans by arrogantly calling them “capital blessings.” This reflected an attitude that building new infrastructure and buying assets was part of their mission, regardless of whether such projects made financial sense.

TRGP’s stock performance says much about how they have allocated capital in recent years. It’s lost almost two thirds of its value over the past year, and 88% from its all-time high in 2014 when Energy Transfer was believed to be interested in acquiring them. Perkins remains with the company as Executive Chairman, having undelivered and been overpaid.

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If the buyback reflects a new respect for the math behind how the company deploys its cash, it represents an overdue shift. TRGP is on track to begin generating Free Cash Flow (FCF) next year. Although buybacks allow plenty of discretion around timing, the market welcomed the announcement that $500MM would be dedicated to repurchasing stock.

TRGP’s buyback program is roughly equal to their expected 2021 FCF, so they’re to complete the program quickly. But it’s worth noting that, if the industry similarly dedicated its 2021 FCF to buybacks, that would amount to $40BN in purchases, twice the size of all the mutual funds, closed end funds and ETFs in the sector. There’s much more FCF available than what’s at TRGP.

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In another sign that the MLP structure retains few friends, TC Energy (TRP) announced they’d be buying in the rest of TC Pipelines (TCP) that they don’t already own. With a 9% yield and limited investor base, TCP isn’t much use as a source of capital. It’s down 23% over the past year, whereas TRP has dropped 15%. Without a ready pool of K-1 tolerant income-seeking buyers, TRP concluded there was little value in maintaining their MLP.

Both TRGP and TRP are buying their own securities, which they deem undervalued. This is positive news.  As more of the industry follows suit, it will provide further support for a beaten-down sector.

On a different topic, Jared Dillian wrote an informative article (see ESG Investing Looks Like Just Another Stock Bubble) highlighting how much of the interest in ESG investing is a fad. Picking companies that possess good ethical values seems pretty reasonable – except that the beauty of ESG lies in the beholder. Because there are no agreed criteria, just about every company can claim such credentials, and most do. For example, coal producer Peabody Energy publishes an ESG report.

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Dillian notes that much of the returns to ESG investing have been driven by liquidity. Inflows have surged over the past year, with Morningstar estimating almost $200BN invested in ESG funds.

Given the numbers involved, few companies can risk being non-ESG. Pipeline corporations are included (watch ESG Investors Like Pipelines), as they should be since increased use of natural gas is replacing coal in power generation. This is the biggest driver of reduced emissions in the U.S.

Confusingly, this means that Williams Companies’ (WMB) ESG credentials are based on successfully reducing demand for Peabody’s product.

MLPs generally don’t show up in ESG lists, because their weak governance (the “G” in ESG) disqualifies them.

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The infinite flexibility of ESG is shown by Lockheed Martin’s (LMT) regular inclusion in the Dow Jones Sustainability Index. Manufacturing products that blow people up sustainably meets the threshold. This is why Jared Dillian is right to say, “…ESG is nothing but a passing investment fad.”

We are invested in LMT and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The positive Presidential Covid test has provided plenty of material for the media. Trump’s known physical disposition is being compared with tables of statistics to assess his likely prognosis. The Financial Times noted that he is in the “vulnerable” population, and gave him 20% odds of requiring hospitalization with a 5% risk of death. Regardless of politics, writing about a living person’s chances of dying strikes me as rather tasteless, although inevitable since it’s the president and the election is a month away.

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More interesting than mortality tables was the reaction on PredictIt, a website that allows modest wagers on numerous electoral outcomes. Many believe that betting markets offer more accurate forecasts than opinion polls, presumably because people are more thoughtful when money is tied to their view. PredictIt showed that the odds of Trump dropping out of the race before November 1 had soared from 4% to as high as 17% on high volume, following his positive Covid test.

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This seems odd, because it’s hard to conceive of any sickness that would cause Trump to withdraw. And if he really does succumb to the virus, his name will remain on the ballot. The only plausible way he’s withdrawing by November 1 is if he concludes an overwhelming defeat is inevitable, when he might declare the entire election a sham hopelessly distorted by mail-in ballot fraud, paving the way for a challenge of the results. This has nothing to do with Covid, and the reaction of PredictIt shows that even the commitment of modest sums of money doesn’t assure a rational view. The Robin Hood trading platform offers another rich source of financially irrational actors.

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The 5% Case Fatality Rate (CFR) referred to by the FT relies on a study from OurWorldInData, which estimated the CFR for different age groups by looking at just four countries (South Korea, Spain, China and Italy). This limited data set took no account of any pre-existing conditions (“comorbidities”). A study in June from the Center for Global Development (“CGD”) took a more precise look, and found that a male aged 70-79, with at least one co-morbidity living in a rich country, had a CFR of 4.35%. Take away any pre-existing condition and the CFR drops by 89%, to 0.48%.

Trump’s pre-existing health conditions, if any, are unknown. He claims to weigh 235lbs, which for his height puts him on the threshold between overweight and obese but well short of severely obese. The 4.35% CFR doesn’t differentiate between one or several co-morbidities.

Trump’s debate performance didn’t show shortness of energy, regardless of whether you found the content appealing or not. There’s little public evidence that he’s chronically sick.

Moreover, the CDG study is from June. CFRs keep improving – although infections are rising again in many countries, fatalities are not. More testing, better treatment and a less fatal strain of the virus are among the possible explanations. It’s likely the CDG study would produce lower figures if the data was updated. And Trump will be receiving the best care available.

On Friday, stocks and crude oil both fell on the news. Pipeline stocks surprised by moving higher, perhaps showing that attractive valuations are finally overwhelming negative sentiment.

The absence of any formal training in virology has not prevented us from offering a data-based view on Covid. So for Trump, the odds are high that he’ll emerge from self-quarantine reporting a mild case easily handled, confirming his assertion that widespread popular fear of the virus is unwarranted.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The merger between Devon (DVN) and WPX Energy (WPX) offers a marked contrast to Occidental’s (OXY) ill-fated acquisition of Anadarko. Synergies are coming from cost savings not revenue opportunities, a defensive move that will likely spur further consolidation. The annual savings of $575MM will cover the modest 2.6% premium paid by DVN in less than two months. OXY paid a 62% premium 18 months ago.

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The new Devon’s dividend policy has been well received – by paying out half the excess Free Cash Flow (FCF) over the current dividend, it allows investors to model different oil price scenarios and their impact on the payout. It’s another acknowledgment that bringing energy back in favor requires greater financial discipline.

A Biden administration has vowed to cease issuing new permits for fracking on Federal land, a policy that would constrain DVN’s Permian output. States benefit from the associated economic activity – the labor involved in drilling, fracking, transportation of water and other inputs to and from the site all create local jobs. In addition, New Mexico for example, where DVN has much of its Permian acreage, receives a 20% royalty. The Biden campaign’s promise to curtail fracking plays well with the base but is unlikely to be popular closer to the regions affected.

Switching gears, society is adjusting to life with Covid, where data continues to show positive trends. New Jersey, population 9 million with the worst fatality rate of any U.S. state, has 421 Covid patients in hospital, down 95% from the peak in April. We spend hours poring over the data, reading and learning about it. As chronicled before, your blogger doesn’t want to get sick and follows mask/hygiene protocols. But we think the market’s rapid recovery reflects the data – vulnerability increases sharply with age and certain risk factors. For the vast majority it’s not fatal.

Anecdotes also inform – here are some of ours:

One good friend at serious risk because of pre-existing health issues endured an extremely mild case of “Covid toes” – chilblains and nothing more. Once it was clear he was not in danger, I applied one of Winston Churchill’s many great quotes to him. “There’s nothing more exhilarating than to be shot at and missed.”

Another friend, in his late 50s and fit with no obvious risk factors, spent four days in hospital on oxygen (but thankfully not on a ventilator). His entire family was infected when their son returned from college. He’s recovered, but doesn’t care to repeat the experience.

The head of Trauma at a local hospital recounted somberly what his life was like in March and April. He’d never seen x-rays and conditions like those that presented. He’s hopeful it’s under control, but also noted that substance abuse is up sharply. Self-quarantines and the stress of financial losses are creating mental health issues.

Another friend recounted how her daughter, at college in Colorado, has endured a series of self-quarantines. As soon as one finished, she was found to have been in contact with another infected person and had to do another two weeks. This has continued for a couple of months, and the daughter is showing signs of mental stress.

My wife is a teacher, and modified in-person classes require wearing a mask all day. Although there’s no evidence than extended mask wearing causes any harm through oxygen deprivation, and it’s routine for health care workers, working with a mask on permanently is a lousy way to spend your day.

Then there’s the older woman in North Carolina who was sufficiently fearful of infection that she insisted her landscapers wear booties over their shoes. She brought home a case of diet coke, and out of an abundance of caution decided to sterilize the cans by placing them in her dishwasher. Well into the dishwasher cycle she was awoken in bed by a series of loud explosions, as the hot water ruptured the soda cans. Convinced her house was under attack, she alerted her neighbors.

Very little attention is being paid to the human and financial costs of mitigation, but we suspect that when a final reckoning is done it’ll be clear that cost-benefit analysis was completely absent.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance

With pipeline stocks having their worst month since the depths of Covid-panic selling in March, investors are wondering when the smart money will finally respond to today’s extreme undervaluation and commit capital. Recent price action makes little sense, something that becomes very apparent in discussions with clients. 2Q20 earnings were as expected, and dividends unchanged. The yield on the American Energy Independence Index, the most representative index of North American midstream energy infrastructure, is now over 10%.

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Two items stand out as the most compelling bullish arguments. The first is that the yield on Free Cash Flow (FCF, the cash flow available after ALL capex spending) is approaching 13% for 2021. We had previously been targeting $30BN for next year, (see Pipeline Earnings Should Confirm Growing Cash Flows), but following second quarter earnings have revised this higher, to $40BN. We don’t know of another sector of the market delivering such a high FCF yield. The broader market’s FCF yield is around 4% and the utility sector, the one most similar to pipelines, has a negative yield.

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The jump in FCF is driven by continued falling growth capex, which peaked in 2018. Pipeline companies are reinvesting less in the business, leaving more for buybacks, deleveraging and distribution increases. Pipeline companies are still investing in growth though, spending on average 6% of their market caps on growth capex.  A sustainable cash flow yield assuming no new projects approaches 20%.

The second bullish item lies in the gulf between perceptions of bond and equity investors in the same company. Enterprise Products Partners (EPD) has 30 year bonds outstanding that yield 3%, less than a third of the distribution yield on their common units (see 4^th chart in Stocks Are Still A Better Bet Than Bonds). Energy Transfer issued 10 year debt early last year, which trades above par following a sharp dip in March. Meanwhile, its common units have sunk to less than half the price at which they traded when the debt was issued (see The Divergent Views About Energy Transfer). While the dour view of equity markets towards the energy sector has driven prices down to where payouts yield 10% or more, long term bond investors see little to concern them. Conventional wisdom holds that bond investors are usually right, because they do more detailed analysis. But that is little comfort for today’s pipeline investors.

Berkshire Hathaway’s $10BN purchase of Dominion Energy’s natural gas pipeline network last month was welcomed by some investors as confirmation of the inherent value in the sector. The natural gas outlook offers more clarity than for crude oil. Covid dramatically altered travel. Gasoline consumption in the U.S. has recovered to within 10% of year-ago levels, but it’s widely believed that office work will never be the same. Increased remote working, less use of public transport, and migration to the suburbs complicate long term forecasts.

By contrast, since natural gas has minimal use in transportation, it is shielded from this uncertainty. Domestic consumption is down slightly from a year ago, but exports are rising and growing demand from developing countries is forecast in the years ahead. Moreover, continued phasing out of coal plants and increased use of renewables are likely to require more natural gas, both here and abroad.

Although California aims to rely on solar and wind for almost all their electricity, recent power outages and high prices make this a strategy few will care to follow. It’s unlikely intermittent renewables can maintain their growth without further reliance on always-there natural gas power plants.

For the twelve months ending in June, natural gas generated 1.6 Terawatt Hours (TW) of electricity. This was an increase of 124 Gigawatt Hours (GWh), or 8%, compared with the same period a year ago. To put this in perspective, total solar power generation over the past year was 81 GWh. On a percentage basis, renewables show high growth, but in absolute numbers natural gas growth dominates. Solar and wind growth combined was 58 GWh, less than half the growth in natural gas. As we switch off coal burning power plants, they are more often replaced with natural gas.

Meanwhile, Berkshire Hathaway has quietly become the sixth biggest operator of natural gas pipelines in America. Buffett presumably sees many years of predictable cashflows from these assets, offered at a cheap price. The smart money is here.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance

More risk more return is a truism of finance, and much else besides. It makes intuitive sense (why bungee jump unless the rush of near-death exceeds the actual risk?) and also has a place in finance, via the Capital Asset Pricing Model (CAPM). This formalizes the relationship between risk and return, allowing securities to be priced, or shown to be mis-priced, relative to one another.

Finding fault in elegant algebraic solutions to markets occupies the minds of many. CAPM has long been known to be flawed – in reality, it turns out that investors pay more than they should for risky stocks, and pay too little for more stable ones. Many of Warren Buffett’s holdings exploit this inefficient bias.

Since taking more risk for less return should leave an investor poorer over time than following CAPM, why does he do it? An explanation that we’ve always liked relies on the misalignment of interests between many asset managers and their clients.

Funds flow in the direction of performance. It’s much easier to find new clients when things are going up, and in that environment it doesn’t pay to deliver middling performance. The simplest way to beat a rising market is to take more risk – hence, actively managed funds are generally found to have a beta above 1.0 (the market’s beta is 1.0).

Such funds should correspondingly underperform when markets are falling – but since it’s harder finding new clients in such an environment, poor relative performance doesn’t hurt much. The  asset manager’s asymmetric business model (“heads I win big, tails I lose a bit”) doesn’t match the investor’s, for whom ups and down of equal magnitude cancel out.

The solution is for clients to reject fund managers who aren’t heavily invested alongside them. This ensures that the linear exposure to market returns is felt by the fund manager and clients, creating a proper alignment of interests. Not surprisingly, your blogger’s fund business fits this model, otherwise you wouldn’t be reading this article.

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Recent market performance has turned this relationship on its head – investors seeking more risk are being handsomely rewarded, while those holding more stable names are watching them languish. It’s like CAPM on steroids – not just more return for more risk, but much more. Low vol stocks are delivering less than half of the returns of the market with slightly higher volatility.

This can be seen by comparing the S&P500 Low Vol High Dividend index (LVHD) with the S&P500.

Through 2016, they mostly tracked one another, with LVHD’s underperformance roughly commensurate with its lower risk. Over the next three years the gap widened. Starting in January, perhaps not coincidentally around the time Covid-19 entered into common conversation, the relationship shifted dramatically. Since then, the S&P500 has made new highs, while LVHD remains 20% off its best levels.

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The second chart takes the ratio of returns between the two indices, and volatility (defined here as the average daily move over the prior year). Prior to 2016 the two lines roughly matched each other, confirming the risk/return symmetry of CAPM. Since then, and most dramatically this year, the relationship has broken. Supposedly less risky stocks are moving more than they should relative to the market, and more risky stocks are over-delivering good returns.

It’s well known that the extreme social distancing and other steps to impede virus transmission favored technology stocks, and anything that helps people live without proximity to others. The winners are not low vol stocks, and the recent shift towards growth has been dramatic.

In the late 1990s, tech stocks generated very strong outperformance against the market as investors grasped the internet’s enormous potential. LVHD doesn’t extend back that far, but other work we’ve done shows the same lagging results of stable stocks. Berkshire’s portfolio was among them.

The subsequent 2000-02 bursting of the internet bubble reversed everything.

The market’s inconsiderate recovery since the lows in March (see The Stock Market’s Heartless Optimism) has been driven by the pandemic’s economic winners, even though many find this an incongruous concept during a severe worldwide recession. Nonetheless, as improving treatments and immunity, eventually aided by vaccines, restore much of our former lives, the market will re-sort the winners and losers. Stable businesses with reliable dividends will be back in vogue.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance

To be an investor in the energy sector nowadays requires a view on the politics of climate change. Exxon Mobil’s (XOM) investor day slides go straight there in the Overview, noting the continued demand growth expected of non-OECD countries and its impact on emissions. The debate over global warming can be summed up thus:  OECD countries seek reduced emissions, while developing countries want higher living standards. The world’s energy-related CO2 output will move on the interplay between these conflicting goals.

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It’s as if the company is warily watching the climate extremists who believe they shouldn’t exist, while investing heavily to meet the demand growth they anticipate. The industry has sharply cut near term growth capex because of Covid. XOM plans a 30% reduction, which they nonetheless described as mostly deferrals, not cancellations. Although they lowered their long term growth capex guidance, they still expect to spend $25-28BN per year (prior guidance was $30-35BN). They see their future in oil and gas.

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Over the past five years, Cash Flow From Operating Activities (CFO) has averaged $29.6BN. XOM is roughly sinking every dollar they generate back into the ground. They still regard themselves as a growth company.

The presidential election is as vital to energy companies as to any sector. Trump’s 2016 victory was hailed by energy executives, who eagerly anticipated deregulation and pro-fossil fuel policies. The last four years have been a bust, as exuberant spending led to overproduction that Covid brutally exposed.

XOM has lost more than half its value since the 2016 presidential election. The company is expected to post a loss this year – the glut of oil and gas that has long weighed on prices has been exacerbated by the pandemic. But the potential for public policy to shift away from fossil fuels has further depressed its cash flow multiple – typically, multiples peak at market lows because the denominator is very low. But XOM’s price to cash flow multiple is at the low end of the past decade’s range.

The presidential cycle is too short to drive XOM’s capital allocation decisions. Nonetheless, they must contemplate the impact of a Biden victory. Future returns are likely to turn on the interplay between green policies that constrain fossil fuel output and the reduced supply that today’s curtailed spending will cause. Although XOM has trimmed its own long term capex guidance, the only way this level makes sense is if they expect industry-wide reductions to be greater.

Democrat policies that seek to lower fossil fuel consumption tend to focus on curtailing supply – it’s easier to control the few hundred companies involved in oil and gas production than to change the behavior of hundreds of millions of people.

XOM isn’t allocating capital based on the election – but it’s also safe to assume that a Biden victory won’t cause those plans to be altered much either. Since Democrat policies will constrain fossil fuel supply, it’s likely that energy prices will rise. A carbon tax would add further upward pressure. Energy prices are low in America, with plenty of room to rise without causing much outcry.

Higher prices support a green agenda, because they make renewables more competitive. Perversely, this could also usher in a period of improved profitability for the energy sector. XOM’s long term capex plans imply that governments and reduced industry capex will be more successful in constraining supply than demand, leaving higher prices as the main catalyst for changed consumer behavior.

On XOM’s 2Q investor call, SVP Neil Chapman noted that around 70% of its investor base is retail. So it’s not surprising that a quick tour of Seeking Alpha’s website reveals dozens of recent XOM articles targeting the self-directed investor. Many of these offer views on the likelihood of a dividend cut – with its shares yielding over 9%, there are many skeptics. It’s clearly at risk. At just under $15BN, the annual dividend is unlikely to be covered by free cash flow until at least 2023, according to a model from JPMorgan. Like MLPs during the exuberance of the Shale Revolution, XOM is investing in the future and borrowing to pay its dividend.

The most likely way for XOM to sustain its dividend is through higher crude oil prices. Their investors may not appreciate this, but a President Biden could be their path to better returns.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The contrast between the pricing of debt and equity issued by pipeline companies is probably the topic that most engages clients in our discussions. In a recent piece on the equity risk premium (see Stocks Are Still A Better Bet Than Bonds) we used the example of Enterprise Products Partners (EPD). Because EPD’s common units yield 3X its long term debt, an investor with the flexibility to move from one asset class to another could achieve a bond-like return by investing a small portion of her capital in the equity.

In short, it seems implausible for the market to be so enthusiastic about a company’s long term debt while at the same time pricing its equity as if prospects are dire. Nonetheless, this fairly describes the current state of the public markets for midstream energy infrastructure securities.

Bond yields are low everywhere, partly the result of inflexible investment mandates by a significant portion of the global investor base. We have touched on this issue before (see Blinded By The Bonds and Real Returns On Bonds Are Gone). The persistence of negative real yields on sovereign debt, and indeed negative nominal yields, such as German ten year government bonds at -0.50%, can hardly reflect a widespread fear of deflation. Fiscal discipline is no contest for fighting the pandemic, and the Federal Reserve has even modified its inflation targeting to allow an overshoot of 2%. The only logical conclusion is that a great many institutional investors own bonds not because they want to – but because they have to.

This situation has been years in the making. Rates fell to previously inconceivable levels during the 2009 financial crisis, and have remained there ever since.

The comparison of Energy Transfer (ET) debt and equity over the past eighteen months offers a striking example of investors’ divergent views.

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ET issued new ten year bonds in early January 2019, with a yield of 5.25%. The chart above shows the path followed by this debt and ET’s common units from that issue date. The two securities tracked one another for a few months before the bonds began to modestly outperform.

During the pandemic, debt and equity both fell sharply. The bonds fell less, reflecting their senior position in the capital structure. But the most striking feature of the chart is that the bonds have almost completely recovered and trade well above par, while the equity remains 50% lower than January 2019.

ET has a poor reputation for corporate governance, something we have noted (see Will Energy Transfer Act with Integrity?). Kelcy Warren’s bare-knuckle approach to business has made many enemies. But the company didn’t suddenly adopt its culture.

Legal challenges with the Dakota Access Pipeline (DAPL) are a potential headwind, but DAPL is around 3.5% of ET’s EBITDA so even a complete shutdown shouldn’t seriously impact the company (see Pipeline Opponents Help Free Cash Flow).

If the company’s prospects are as poor as implied by the weakness in its equity price, its debt has no business trading with a 4% yield. Conversely, if its balance sheet is as solid as this yield implies, the equity is mispriced.

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Just as bond investors seem to buy yield-less government bonds without regard to value, equity investors in this sector seem to sell with equal disregard for the outlook. MLP funds have labored under outflows virtually all year. In conversations with investors, the biggest source of frustration is that prices don’t reflect fundamentals, and are often under pressure. The consequent fund outflows are, for now, drawing more selling. Nobody worries about pipeline stocks being overpriced (a preposterous notion). They do ask when the stocks will go up.

The answer is, when the current cohort of frustrated sellers is done. It could be any day.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Growth isn’t always good. The Shale Revolution led to enormous growth in U.S. oil and gas output, but abundance pressured prices and, for investors in U.S. exploration and production, it’s been a bust. Midstream energy infrastructure joined in the race for growth projects – but not every investment was accretive. Some, like Plains All American (PAGP), have seen their stock price lose 90% of its value since 2014. It’s the result of serial bad capital allocation decisions. The drop in Permian crude output caused by Covid will leave PAGP with excess pipeline capacity in the region.

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Energy investors have become so wary of growth capital expenditures that they now cheer when a company reduces future spending. Enterprise Products Partners (EPD) has managed their business better than most over the past few years. Their investment in new infrastructure plus acquisitions peaked in 2014, and had already resumed its downward trend last year before the pandemic caused an industry-wide reassessment.

EPD last week canceled their planned Midland to Echo 4 (M2E4) pipeline carrying crude from the Permian to storage facilities on the Gulf of Mexico. Although much of the 450,000 barrels per day of capacity was already committed, EPD was able to get its customers to agree to extend the term of their agreements while reducing near term volume commitments. The crude oil originally intended for M2E4 will now move on other parts of EPD’s pipeline network.

Excess pipeline capacity out of west Texas is the most visible consequence of Covid on U.S. oil output. EPD’s move helps them but doesn’t solve the problem for other pipeline operators. “The Permian will still be significantly overbuilt” warned Ethan Bellamy, managing director of midstream strategy at East Daley Capital Advisors.

On Wednesday morning when the news was announced, EPD’s stock opened strongly and outperformed the American Energy Independence Index (AEITR) by 2% on the day. EPD estimates its growth capex will be $800MM lower over the next couple of years as a result, continuing the trend of recent years.

Lower growth spending means more free cash flow. CEO Jim Teague commented that, “The capital savings from the cancellation of M2E4 will accelerate Enterprise toward being discretionary free cash flow positive, which would give us the flexibility to reduce debt and return additional capital to our partners, including through buybacks.”

This is welcome news, and represents the new normal in the pipeline business.

We expect free cash flow for the industry to more than double this year. From our calls with investors, there’s substantial interest in today’s attractive yields, especially following 2Q earnings. EPD stands out with a distribution yield 3X their 30 year debt. As the industry continues to generate more cash, equity buyers will start to appreciate the long term stability of the best run businesses, as bond buyers already do.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance. We are also invested in PAGP and EPD via the SMAs and mutual fund we manage.