Few would believe there’s a midstream energy infrastructure stock that’s tripled this year, but New Fortress Energy (NFE) has done just that. Happily, it’s a component in the American Energy Independence Index (AEITR). This year’s strong performance has NFE approaching a top ten position, since AEITR is market cap weighted.  

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NFE was founded in 2014 by Wes Edens, already a billionaire as a co-founder of Fortress Investment Group (FIG). They transport Liquified Natural Gas (LNG), and have five facilities located around the Caribbean and in Miami. NFE claims that their innovative use of smaller LNG ships makes clean natural gas available to ports that otherwise don’t have the infrastructure. These vessels are called Floating Storage Regasification Units.  NFE’s investor slides emphasize their ability to bring cleaner-burning natural gas to island nations such as Jamaica, thereby reducing their reliance on dirtier, oil-based fuels for power generation.  

NFE went public last year as an LLC electing to be taxed as a corporation, and earlier this year converted to a regular c-corp. Their stock performance was unremarkable – that is, it tracked AEITR – until early July when it took off.  

Although NFE already had a positive environmental story to tell, in recent months they have begun discussing plans to transport hydrogen, an emission-free fuel. So far, management has done little beyond muse on conference calls about their interest in hydrogen and how great it would be if the economics allowed it to compete with natural gas. There are no hydrogen-related revenues, and analysts don’t expect the company to make substantial capital commitments in this area.  

Nonetheless, there’s little else to justify NFE’s recent meteoric rise beyond its stated interest in hydrogen. The word came up 32 times in the 2Q earnings call on August 3rd (up from 12 in the 1Q call), although obliging questions from sell-side analysts helped. CEO Edens noted that, “75% of all of the elements in the universe are hydrogen, 24% helium, 1% other. So the world is full of hydrogen.” 

This doesn’t mean NFE won’t access new technology that makes hydrogen a commercially viable fuel. Pipelines and other infrastructure dedicated to natural gas might be repurposed to handle this zero-emissions fuel, which would transform the malaise felt by investors towards the sector. But NFE’s stock has shot up recently mostly on the hope of a breakthrough. NFE’s green hydrogen division (named Zero) has no revenues. But just having a business unit with that name can only help an energy company. 

NFE’s recent rise hasn’t been overlooked by other midstream companies. Kinder Morgan (KMI) chairman Rich Kinder included the words “green hydrogen” when he opened Tuesday’s earnings call. 

Thursday’s presidential debate touched on climate change. Regardless of who you’re voting for, there can’t be much doubt that Trump won the exchange. Biden’s talk of a moral imperative to reduce carbon emissions isn’t likely to resonate when the economy is virus-ravaged. Trump correctly noted that China and India plan to keep increasing their CO2 emissions for at least another decade. China burns half the world’s coal.  

This component of climate change realpolitik receives little popular attention.  Climate change policies aren’t currently costing much, unless you live in California where electricity is greener, more costly and less reliable. But if America does adopt policies to aggressively reduce emissions, Trump’s point is that many will balk at higher domestic energy prices when the biggest emitters remain focused on raising living standards. A Biden victory will lead to a more vigorous debate, exposing a huge flaw in the Paris agreement. 

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

MLPs have been losing relevance to the midstream energy infrastructure sector for years. The Shale Revolution caused them to evolve from reliable generators of income to growth-seeking enterprises. As upstream companies plowed money into drilling, pipeline companies felt compelled to add new infrastructure to service them. The capital spending spigot had already been ratcheted down since 2018, with investors rebelling against the culture of always building. The hit to demand from Covid accelerated a trend already in pace.  

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MLPs represent around a third of the pipeline business. This has left MLP-dedicated funds increasingly challenged to find enough names to build out a portfolio. It’s a dilemma we’ve forecast for a long time (see The Uncertain Future of MLP-Dedicated Funds, April 2018). Such funds, most notably the Alerian MLP ETF (AMLP), were already burdened with an inefficient structure (see Uncle Sam Helps You Short AMLP, July 2018).  

The MainStay Cushing MLP Premier Fund (CSHAX) has decided to bite the bullet and abandon their anachronistic structure. In recent weeks they’ve been quietly informing clients that they plan to limit MLPs to 25%, because of the “significant contraction” of MLPs. It’s taken them longer than it should, but they’ve accepted that the MLP business has changed. Serial distribution cuts imposed on income seeking investors have lost those investors to the sector for good.  

CSHAX is around $500MM in AUM. Bringing their MLP holdings below 25% will require them to shed 75% of their portfolio, around $375MM, over period of months. MLP funds have seen around $6BN of outflows in the past year, and this has weighed on prices. Even so, the CSHAX repositioning should be manageable. 

But what if other MLP funds reach the same conclusion? The Invesco Steelpath family of MLP funds is over $3.5BN. Center Coast and Goldman each have another $800MM. And AMLP is $3.3BN. There’s over $13BN invested in flawed, MLP-dedicated funds.  

MainStay Cushing’s move is logical, but nobody will want to be the last one jumping. They’re not the first either. Some smaller closed end funds have combined and become RIC-compliant by limiting MLPs to 25%. The Kayne Anderson MLP/Midstream Investment Company recently became the Kayne Anderson Energy Infrastructure Fund (still KYN). Dropping MLPs is a developing trend. 

It should induce investors in all MLP-dedicated funds to ponder their fund’s future. If bigger funds follow MainStay Cushing, the MLP sector could find itself having to absorb an indigestible amount of sales. Alerian calculates the market cap of MLPs at $139BN, but it’s only $72BN when adjusted for float. For example, the Duncan family’s 32% ownership of Enterprise Products Partners (EPD) doesn’t provide any liquidity. The remaining MLP-dedicated funds are almost 20% of the market. 

MLPs are cheap by any reasonable measure. We’ve noted the yawning gap between EPD’s debt and equity yields (see Stocks Are Still A Better Bet Than Bonds). Bond and stock investors are poles apart in their assessment of the sector. But the risk investors in MLP-dedicated funds face is that portfolio shifts by competitor funds depress MLP prices, driving down their own fund’s NAV. 

The near–term future of MLP-dedicated funds is unclear. But the time for such vehicles has passed, and it seems inevitable that funds invested in midstream infrastructure will limit MLPs to 25%. You just don’t want to be in the last fund to decide to make the shift.  

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

Although we rarely write about technical analysis, charts are helpful in showing visually where prices have come from. We also have a good number of clients who use charts to form investment opinions. This is especially true when it comes to changing portfolio allocations. Recently, bullish energy sector charts have come up in conversations.

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The 200-day moving average is widely used, and often gives a signal when crossed by a faster moving average, such as the 50 day. From 2016 to early this year, the pipeline sector stayed within a 20% range, and moving averages offered little of use to the technician.

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Following the steep drop from January to March, the trading range for the American Energy Independence Index (AEITR) has become steadily tighter. Lower highs and higher lows will soon be resolved, as it breaks out of its current formation.

The 50-day moving average crossed the 200 day on Tuesday. Some may prefer to see it happen more decisively, with the 50-day moving sharply higher. Nonetheless, by this definition the sector has begun a new uptrend. The index itself has remained above both moving averages since Wednesday.

There’s also a downward sloping trendline, against which the index is bumping. A move up through this would confirm the bullish signal from the moving averages and chartists would interpret this as positive.

Proponents of technical analysis will tell you that it improves the timing of their trades. The fundamentals for pipelines have looked encouraging to us for several months now, with free cash flow set to double this year (see Pipeline Cash Flows Will Still Double This Year). We wrote that in mid-May, and it’s looking increasingly prescient with midstream energy infrastructure 6% higher since then. But with a yawning gap between yields on bonds and equity from investment grade issuers (see Stocks Are Still A Better Bet Than Bonds), there is substantially more upside. Fixed income markets are far more positive about big pipeline companies than are equity markets. Bond buyers have a reputation for doing more careful analysis, since their upside is receiving coupons and their downside is losing everything. They are right to be constructive.

Bullish fundamentals are now being confirmed by technical analysis.

Sentiment remains extremely cautious. Although we don’t have any numbers on this, conversations with investors often reveal interest in valuations but nervousness about buying just before a big drop. The energy sector has done that to people in the past. A lot of these people represent potential buyers – interested in committing capital but looking for some signs that they’re not alone. Waiting for the election is a common refrain. A Biden victory is priced in, and we think could be positive for pipeline stocks (see Why Exxon Mobil Investors Might Like Biden).

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

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