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.

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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.

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.

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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.

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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.

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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.

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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.

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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.

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.

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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.

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.

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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.

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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.

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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.

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.

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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

Sentiment among energy investors remains poor. The S&P E&P ETF (XOP) is -21% for the year. Energy has sunk to 4% of the S&P500. The Alerian MLP Infrastructure index (AMZIX) is -3% YTD and reached a low of 44% off its August 2014 high last week. This contrasts with the S&P500, which is +26% for the year. MLP tax loss selling has caused further downward pressure, since so many investors have realized gains in other sectors to pair against energy losses.

Although energy has been weak, wide performance divergences exist. Midstream energy infrastructure has done far better than the E&P companies that are its principal customers. Within that, pipeline corporations have done better than MLPs, which continue to suffer from erosion of interest among their traditional income-seeking investor base. Canadian corporations are among the best performers. TC Energy (TRP, formerly Transcanada), is +50% for the year including dividends, even handily beating the S&P500 with its 26% gain.  Few investors in midstream energy infrastructure realize how well TRP has performed, unless they own it. Enbridge (ENB), North America’s biggest midstream energy infrastructure company and also Canadian, is +31%. Pembina (PBA), a less well known Canadian pipeline company, is +27%.

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Like their banks, Canadians pipeline companies tend to be run more conservatively. Over the past five years they’ve also set themselves apart from the rest of the sector. Their U.S. cousins would do well to adopt some of their disciplined capital allocation and prudent management practices. These three companies represent 55% of the 2019 Free Cash Flow (FCF) we project for the industry. Their performance supports the case that growing FCF leads to a higher stock price (see The Coming Pipeline Cash Gusher).

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The Alerian MLP ETF (AMLP) is a rich source of opprobrium on this blog, because of its flawed tax structure (see MLP Funds Made for Uncle Sam). It does retain one useful feature though, in that it’s relatively easy to short. Big pipeline companies are under-represented in the Alerian index, because most of them are not MLPs. So AMZIX is stuffed full of what investors don’t want.  AMLP follows AMZIX, albeit from a distance. Because of its structure, since inception performance of 1.6% is only half its benchmark of 3.2%. AMLP is the worst performing passive index fund in history. This year AMZIX is 15% behind the investable American Energy Independence Index (AEITR), which is 80% corporations, including the abovementioned Canadians.

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Comparing the two indices, one can see the recent sharp divergence in performance, which was probably exacerbated by tax-loss selling of MLPs. Short AMLP and long an AEITR-linked security has been a profitable trade. AMLP’s tax drag hurts in a rising market, where its flawed structure impedes its ability to appreciate with its underlying portfolio. But recent weakness has been led by the MLPs that predominate in AMLP, highlighting the importance of being in the right kinds of companies in this sector. Investors are favoring well-run Canadian pipeline corporations and shunning MLPs.

The Canadian pipelines offer powerful evidence that it’s possible to generate steady returns in this business. Those U.S. companies that perform well over the next couple of years will do so by adopting more of their culture from north of the border. Assuming FCF grows as we expect across the sector, performance of the Canadian stocks suggests positive returns should follow.

We are invested in ENB, PBA and TRP. We are short AMLP

We manage an ETF which tracks the American Energy Independence Index

Managers of client capital invested in midstream energy infrastructure have had to explain recent weak performance to investors frustrated at missing out on the buoyant S&P500. We summarized the many conversations we’ve had last week (see When Will MLPs Recover?). The sector is up this year, although investors in MLP-only products like the Alerian MLP ETF (AMLP) are lagging the stock market by 25%, and pipeline corporations by 14%.

Energy remains out of favor to be sure, but midstream energy infrastructure bankruptcies remain rare. As much as fund outflows have pushed equity valuations to levels indicating financial stress, bond investors don’t share the angst. Long term investment grade debt in many cases yields less than the dividend on a company’s common equity.

If schadenfreude is your thing, consider the portfolio managers of Global Infrastructure Partners’ (GIP) GIP III fund. In July of last year, they invested $3.125BN into Enlink Midstream LLC (ENLC) and Enlink Midstream Partners, LP (ENLK). Following a simplification a few months later, GIP III wound up with 46.1% of ENLC, the surviving entity, and control of the managing member. $1BN of the $3.125BN was funded with a term loan, because private equity investors always add debt to juice their returns. So GIP III invested $2.125MM of equity.

We don’t use leverage ourselves. Midstream energy infrastructure businesses already operate with leverage that credit rating agencies assess in setting their credit ratings. To add borrowings on top is to reject the agencies as needlessly pessimistic. GIP III wanted a little more upside.

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ENLC’s entire market capitalization is currently $2.6BN, valuing GIP III’s 46% stake at $1.22BN. After the $1BN term loan, GIP III’s $2.125BN equity investment is worth $225MM. On a mark-to-market basis, they’re down around 90%. Losing that much that quickly, even in this sector, is stunning. It shows that the most sophisticated institutional investors can get it spectacularly wrong. Few, including us, thought ENLC could sink this low. Its dividend yield is now 20%

GIP has built a strong reputation investing in infrastructure. They manage $51BN across various portfolios (or perhaps more correctly, now $49BN after adjusting for ENLC). They raised the funds for GIP III on the basis of their past track record. They even highlighted their ENLC investment in the marketing materials for the next fund, GIP IV.

Of course there’s no gain in someone else’s losses – but ENLC investors need to consider what GIP will do. Private equity firms generally avoid holding publicly traded securities – the constantly fluctuating valuations add unwanted NAV volatility.

Included in the list of Risk Factors in ENLC’s 2018 10K is:

“GIP has pledged all of the equity interests that it owns in ENLC and ENLC’s managing member to GIP’s lenders under its credit facility. A default under GIP’s credit facility could result in a change of control of the Managing Member.”

The paragraph goes on to explain that, “…if a default under such credit facility were to occur, the lenders could foreclose on the pledged equity interests.”

So the lender could, in theory, seize GIP III’s equity stake in ENLC and sell it to pay back the loan. It’s likely that whatever loan covenants were attached have already been breached, and in the apparent absence of any large sale of ENLC stock, one must assume that a renegotiation has taken place.

On ENLC’s recent earnings call, James Carreker of US Capital Advisors pursued a line of questions relating to GIP’s term loan, noting the reference to it in ENLC’s Risk Factors section of its 10K. CFO Eric Batchelder refused to comment, and offered to “…talk about it offline.”

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GIP’s intentions with respect to its ENLC stake are a material consideration for the other investors. ENLC’s 10K warns that, “our operating agreement limits the liability of, and eliminates and replaces the fiduciary duties that would otherwise be owed by, the Managing Member and also restricts the remedies available to our unitholders for actions that, without the provisions of the operating agreement, might constitute breaches of fiduciary duty.” Although ENLC is an LLC, like other publicly traded partnerships in this sector it provides weak investor protections.

The 10K  goes on to point out: “Our operating agreement contains provisions that eliminate and replace the fiduciary standards that the Managing Member would otherwise be held to by state fiduciary duty law.”  Further on: “…whether or not to seek the approval of the conflicts committee of the board of directors of the Managing Member, or the unitholders, or neither, of any conflicted transaction.”

ENLC’s operating agreement gives GIP an extreme asymmetric position over public holders through its role as managing member. It may have backfired on them. This blog regularly chronicles management self-dealing (see Blackstone and Tallgrass Discredit the MLP Model for example). Growing concerns of abuse and unethical (if legal) behavior have likely caused generalist investors to avoid ENLC, because of GIP’s power to similarly exploit other investors. GIP’s selective rights and canceled obligations have probably hurt ENLC’s stock price.

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Given the substantial drop in ENLC since GIP III’s investment, you might think acquiring the rest of the company would be compelling. GIP III likely doesn’t have the ability, and because the different pools of capital managed by GIP have different investors, there would be inevitable conflict of interest concerns if, say, GIP IV bought the balance. It could be perceived that one fund was bailing out another’s poor investment decision. Private equity has to deal with that issue all the time though, and it’s likely they could find a solution. It’s similar to the conflicts committees that usually rubber stamp MLP decisions on capital allocation.

There’s probably a strong motivation for GIP to resolve this issue by year’s end, when GIP III’s annual financials will include ENLC’s public stock price performance. You can be sure they’re pondering their options right now.

We are invested in ENLC and TGE

Coal is by any measure an environmental and climate disaster. The world relies on coal in various forms for 27% of its primary energy, and it’s responsible for  40% of its CO2 emissions from fuels. Although it possesses lower energy density than oil or natural gas, coal is relatively easy to transport and store which explains its widespread use. It powered the industrial revolution before rich countries started switching to cleaner-burning natural gas due to local pollution. Today, China consumes half the world’s coal.

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A big idea to combat climate change is for the world to phase out coal, replacing it with natural gas. This is already happening to some degree in the U.S. for power generation. Natural gas provides 37% of U.S. power, up from 34% last year. Coal’s share is 25%, down from 28% last year and heading to 22% in 2020.The recent bankruptcy of Murray Energy is a consequence.

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Coal has its proponents, including all the industrial users of coal who have invested in processes that rely on it, as well as the coal producers themselves. But the math is that if the 150 billion BTU-equivalent of primary energy generated from coal was instead produced with natural gas, it would roughly halve the CO2 emissions per unit of energy. This would in turn reduce global emissions by 6.6 Gigatons, around 17% and more than the total emitted by the U.S. Climate extremists focused on solutions would push for even greater exports of cheap U.S. natural gas, perhaps supported by the sale of U.S. gas-fired power plants. It’s not as radical as moving to centrally planned economies running on solar and wind, but has the significant advantage of being feasible with today’s technology. Abundant natural gas offers a huge opportunity.

Moreover, coal causes local pollution wherever it’s burned, including sulfur, mercury, lead and arsenic. It emits high concentrations of very fine particulate matter, which cause respiratory damage. Estimates of annual coal-related deaths in the U.S. range from 7.500 to as high as 52,000. For comparison, the U.S. experiences around 40,000 auto-related deaths annually. In China, which burns six times as much coal as the U.S. and has less restrictive pollution rules, estimates of smog-related deaths are as high as 670,000.

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America’s enormous success in producing natural gas has crushed the stock prices of many E&P companies.

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Chesapeake (CHK) was the poster child for the Shale Revolution and natural gas under the late Aubrey McClendon. In an SEC filing the company warned that low natural gas prices “raises substantial doubt about our ability to continue as a going concern.”

Range Resources (RRC), Comstock Resources (CRK), Southwest Energy (SWN) and Antero Resources (AR) are among those who have destroyed vast amounts of investor capital in producing abundant natural gas.

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Almost a decade ago we were following RRC, SWN and CRK more closely, meeting with management and examining the growth story. Production success has been a poisoned chalice. Increasing output has weighed on prices, recalling the early days of dot.com businesses who sought to cover operating losses by increasing volumes.

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Nonetheless, production continues to increase. In the Permian in west Texas, the two most active drillers are Exxon Mobil (XOM) and Chevron (CVX), validating the opportunity of shale as long as it’s exploited by companies with low production costs and strong balance sheets.

Natural gas is increasing its share of the world’s power generation, providing access to cheap energy and lowering emissions. It’s just not clear that the early, smaller E&P companies will survive to benefit.

It’s a year until the next presidential election. The S&P500 is making new highs, reflecting the persistence of fund flows into equities. Quarterly earnings have been coming in ahead of expectations, but still down 1% year-on-year. Down less than expected counts as up for traders.

It’s also worth noting that expectations are for a 10% increase in S&P500 earnings next year, according to bottom-up estimates compiled by Factset. A year ago, we noted that equity returns are often strongest in the year following midterms – i.e., preceding presidential election years (see What the Midterms Mean for Stocks). 2019 looks as if it will confirm that pattern. The S&P500 is up 25% YTD.

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This is probably due in part to the fact that S&P500 earnings growth tends to be stronger than average in election years, and markets being forward-looking tend to anticipate that.

Next year’s anticipated 10% S&P500 earnings growth is above the 8% annual average since 1960, but below the 13% average for election years. The 2017 tax reform, which slashed corporate taxes, boosted 2018 corporate profits, making for tough comparisons this year. But overall S&P earnings are set to be up 50% during this four-year presidential cycle, fifth best out of 15 since 1960. Equity investors have done well.

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We won’t offer an election forecast derived from stocks, nor a market return based on next year’s election; there are plenty of better qualified prognosticators. Suffice it to say that the synchronization of corporate profits with the election cycle has continued into 2020. There’s no clear pattern showing one party’s control of the white House is better for S&P500 earnings over another.

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The Equity Risk Premium (S&P500 earnings yield minus the yield on ten year treasury notes) has favored stocks for several years. Low interest rates leave equities one of the few asset classes with a chance to deliver returns ahead of inflation. It remains substantially wider than the 60 year average, and 10% earnings growth next year would accentuate the appeal of stocks. The Federal Reserve has gradually accepted the reduced real rate that bond investors have long felt was appropriate (see Real Returns On Bonds Are Gone). Perhaps the biggest unanswered question for investors today is why long term rates around the world are so low, with U.S. the highest among G7 nations. Part of the explanation is inflexible investment mandates (see Pension Funds Keep Interest Rates Low). It’s the most important factor showing stocks are cheap. There are few good alternatives.

Earnings season for pipeline companies has provided few surprises, offering little to offset fund outflows, which continue to weigh on performance. Therefore, the Tallgrass (TGE) call last Wednesday promised to be more interesting than most. Blackstone’s (BX) offer to take private the 56% of TGE it doesn’t already own has focused attention on a sideletter many investors find objectionable.

In January, BX bought 44% of TGE at $22.43. The General Partner (GP) of TGE, owned by CEO David Dehaemers and others, was separately valued at around $480MM, which meant that these insiders received $26.25 for their TGE units. A sideletter agreement allowed that if BX buys the rest of TGE within a year, regardless of price, the insiders will receive at least $26.25 for their remaining units (see Blackstone and Tallgrass Further Discredit the MLP Model).

To his credit, Dehaemers confronted the sideletter issue during the earnings call. He understands that resolution of BX’s offer is the biggest question hanging over the stock. Investors who long believed they were invested alongside management feel betrayed, because the sideletter places a floor under management’s sale price without providing similar protection to other investors.

Dehaemers seems to think critics are overlooking the fact that his GP stake justified additional value, and that the special terms for management are fair. The problem is not the additional value extracted for selling the GP, even though its valuation seems arbitrary. Breaking the alignment of interests is what’s so offensive.

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The sideletter’s result is that Dehaemers and his management team are indifferent to the price BX offers for the rest of the units below $22.43, since in any consummated transaction they are assured of receiving $22.43 (plus $3.82 per unit for their GP stake, or $26.25 in total). This is why BX’s $19.50 offer is so galling. Perversely, as TGE’s stock price weakened in August, it increased the likelihood of BX offering to buy the rest of the company. Therefore, as TGE fell it raised the probability of management receiving $22.43 for their units. Dehaemers was completely misaligned with his investors. Blaming TGE’s stock weakness on institutional sellers misses the point. Dehaemers had willingly given up his right to acquire any units in the open market, and had little incentive to provide business updates that might have arrested the decline.

Dehaemers insisted on a floor to sell his remaining shares, guaranteeing him the original price, as a pre-condition to staying invested and agreeing on a non-compete if he leaves the company. Because this changed his incentives relative to other investors, maintaining alignment with them required that he either obtain the same floor for all investors, or not seek one for himself. In doing so he violated their trust, which relied on this continued alignment of interests.

The consequences extend beyond just TGE. By demonstrating how easily the senior managers of a partnership can negotiate preferential terms for themselves, TGE has followed in the steps of Energy Transfer (ET), whose 2016 issue of convertible preferred securities to management on highly attractive terms led to a class action lawsuit (see Will Energy Transfer Act with Integrity?). Partnerships trade at a valuation discount, reflecting the weakness of investor protections (see Energy Transfer’s Weak Governance Costs Them). The MLP-dominated Alerian MLP Index (AMZX) has lagged the corporation-dominated American Energy Independence Index (AEITR) by ten percentage points this year (see MLPs No Longer Represent Pipelines).

Regardless of how the BX offer is resolved, MLP investors now have to consider the possibility of management crafting lucrative deals for themselves, a risk typically not present with conventional corporations because of tighter governance. It’s why the biggest ESG funds invest in pipeline corporations but not MLPs (see ESG Investors Like Pipelines).

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

SL Advisors is also the advisor to an ETF (USAIETF.com).