2013 and 2014 were great investing years. The S&P500 was +32% in 2013 and followed up with +14% the following year. MLPs also delivered strong performance. As long-time investors know, the Alerian MLP Index peaked in 2014 and even now remains 35% lower, while the S&P500 has continued to scale new heights.

Investors in MLP-dedicated mutual funds and ETFs yearn for a repeat, and probably feel entitled to one. Investors in such products are generally not looking for 5-10% either. Given what the sector has endured, the returns of 4-5 years ago would not be amiss. Last week the sector finally turned positive YTD — such optimistic thoughts do not seem out of place.

Those hoping for such may want to consider their choice of vehicle. MLP-dedicated funds are taxed as corporations, and so they pay taxes as well as other operating expenses before delivering their taxable returns to investors. These funds labored under some of the highest expense ratios in the industry during those banner years. Their tax expense is fully disclosed, but still in our experience poorly understood. Sitting with a financial advisor and educating him on a previously unfathomable expense burden still routinely elicits embarrassment and shock.

The chart below shows the 2013-14 expense ratios of some of the biggest MLP-dedicated funds. Although corporate tax rates are now lower, the structural inefficiency persists. If MLPs do manage a couple of years of outsized performance, investors are likely to be surprised at the expenses that are deducted from their returns. Getting the sector right but picking the wrong investment is an avoidable tragedy (see AMLP’s Tax Bondage).

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In 2013, the funds in the chart had an average expense ratio of 9.4%. With average returns of 18.2%, around a third of the gross return was eaten up in expenses, most of which was corporate taxes. Six years ago in The Hedge Fund Mirage, I showed how the profits had split very unevenly between fees to managers versus returns to clients. It surprised many, although not the fund managers who well understood and enjoyed the imbalance. The 2013-14 result in MLP funds was similar, although the offending expenses in this case are corporate taxes rather than manager fees. Nonetheless, considering that investors still have to meet their own tax liability on the net investment results, these look like products that the Federal government might have designed.

Promoters will explain that all MLP funds are taxable, which is true. When investing in energy infrastructure meant MLPs, that was perhaps a defensible argument. But many of today’s biggest energy infrastructure businesses have abandoned the MLP structure. They’ve found the investor base to be fickle, limited to older wealthy Americans who prefer income and are unwilling to finance the growth opportunities opened up by the Shale Revolution. These long-time buyers have been badly abused, with multiple distribution cuts and adverse tax outcomes when their MLP simplifies by combining with its corporate parent. It should be no surprise that MLP yield spreads versus ten year treasuries remain historically wide.

In May, Williams Companies (WMB) rolled up their MLP into their corporate parent (see Transco Dumps Its MLP). Enbridge (ENB) also simplified their structure on the same day. Both cited regulatory uncertainty caused by the FERC ruling (see FERC Ruling Pushes Pipelines Out of MLPs). But the difficulty of raising equity capital for an MLP is an issue for many.

As a result, tax-burdened MLP-dedicated funds are now confronting a shrinking set of opportunities. They are becoming an anachronism, as the energy infrastructure industry steadily leaves the MLP buyer behind in favor of a far bigger set of investors.

Moreover, the shrinking MLP universe is going to create further challenges for such funds (see The Alerian Problem). At the annual MLP conference in Orlando, many participants commented that an MLP-only index was now inadequate, no longer reflective of the energy infrastructure sector (see The Uncertain Future of MLP-Dedicated Funds). MLPs are less than half of North American midstream energy infrastructure, a point recently tweeted by Hinds Howard of CBRE Clarion Securities (@MLPGuy).

Managers of MLP-dedicated funds are telling their clients not to worry — as they would given their MLP-centric business model. But a shrinking index is rare in Finance, and offers the fund manager few good options: (1) Do nothing, and hope your clients tolerate a more concentrated portfolio with smaller names; (2) Start holding corporations as well as MLPs. This would require an ingenious explanation, because you’d now have taxable corporations sitting in a tax-paying fund delivering taxable returns to investors, a solution with poor optics; (3) Switch to a broader index and become RIC-compliant. This is the nuclear option, since it requires an MLP-dedicated fund to shed 75% of its holdings in order to come under the 25% MLP limit necessary to be RIC-compliant. If the $10BN Alerian MLP ETF (AMLP) sold $7.5BN of MLPs, they’d find that by the time they were done with that, for MLP prices, down is a long way. It’s unlikely they could seriously contemplate such a choice — their investors should hope they never do.

AMLP is the biggest of these flawed funds. In 2013-14 its expense ratio was 8.6% and 8.8% respectively. Today, AMLP has modest unrealized losses; a continued recovery in the sector will soon turn these into gains, resulting in AMLP once again incurring a Deferred Tax Liability along the lines of 2013-14. Since it’s close to the inflection point at which it becomes a taxpayer, shorting AMLP exploits the attractive asymmetry of a tax drag impeding its rise, while it will still reflect the full force of a market drop. It’ll rise at approximately only 77% of the index, and fall 100% of it. AMLP as a short can be combined with a long position in a portfolio of energy infrastructure corporations, or even with a correctly structured, RIC-compliant fund with no tax drag. Such a paired trade combines long positions focused on energy infrastructure corporations, which have very strong fundamentals, with a short position focused on the MLP structure than is increasingly being abandoned.

We are long ENB and WMB. We are short AMLP.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

This year’s MLPA conference at the Hyatt Regency Orlando reflected the sector’s current transition. It was rebranded from years past to be the MLP & Energy Infrastructure Conference (MEIC), now open to energy infrastructure corporations as well as MLPs. Revealingly, this inevitable recognition of the continuing shift of MLPs to a corporate structure was not embraced by former MLPs. Kinder Morgan (KMI), Oneok Inc (OKE) and Williams Companies (WMB) all declined to participate.

Since almost no corporations showed up, it was an MLP conference after all, albeit with fewer companies and what seemed like a smaller crowd. The conference took place in a more modest set of ballrooms at the Hyatt while another, unrelated event occupied the larger space. The managers of MLP-dedicated, tax-burdened funds (see AMLP’s Tax Bondage) are alone in their unequivocal support of MLPs as the best way to invest in energy infrastructure. The diminished conference must have been a sobering assault on their conviction.

Clearly, energy infrastructure corporations see no value in being associated with MLPs. Moreover, in the smaller group meetings of a half dozen or so investors with management teams, most MLPs were left defending their decision to persist with the MLP structure. “When will you convert to a corporation?”, known as the Simplification Question, came up in every single meeting we attended, even when the company was doing very well (such as Crestwood, CEQP). One management team had an internal over/under bet on how many times they’d be asked all day – trading was at 75.

The industry’s shift to a growth model has already alienated their traditional, income seeking investor base by resulting in widespread distribution cuts to pay for new projects (see Will MLP Distribution Cuts Pay Off?). This is a self-inflicted wound, but the March FERC (Federal Energy Regulatory Commission) Policy Statement may turn out to be nearly as ruinous (see FERC Ruling Pushes Pipelines Out of MLPs). A panel of lawyers discussed the thinking behind the change, which was cited by both WMB and Enbridge (ENB) last week as they rolled up their MLPs into the corporate parent (see Transco Dumps its MLP). Attendees overflowed from the cozy ballroom.

It seems highly likely that FERC  gave only brief consideration to the impact of disallowing income tax expense from cost-of-service natural gas pipeline contracts. The idea that an MLP could expense taxes paid by its equity holders in calculating rates strikes some as odd, but it had been accepted practice for many years. Following a successful court challenge in 2016, FERC waited almost two years to implement the regulatory change required by the judge’s ruling. FERC’s ponderous approach, as well as subsequent questions over precise implementation details, provided further impetus to abandon the uncertainty of the MLP structure. Corporate-owned pipelines are not similarly affected, and so represent a more predictable form of ownership.

One odd twist is that although disallowing an expense ought to benefit the customer, by rolling up into a corporate parent an MLP’s assets are revalued from historic cost to market values. This could ultimately lead to higher tariffs, since cost of service must include an appropriate return on a now more highly valued asset. The lawyers on the panel were unwilling to criticize FERC, since they often represent clients appealing the regulator’s decisions. Among attendees, there was widespread consensus that FERC had screwed up. However, the panel held out little hope of a policy change unless ordered by a Federal court.

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Meetings with management teams weren’t only about changing structure. Fundamentals are very strong across the U.S. energy industry, and business is booming for midstream infrastructure. Pursuit of growth projects, while maintaining healthy distribution coverage and reducing leverage, was the theme. The Shale Revolution has long been a volume success, but it’s finally translating into a financial success as well. Investors have had a long wait.

Although the Permian is producing record amounts of crude oil, one CEO said he thought associated natural gas output could reach 30 Billion Cubic Feet per Day (BCF/D), versus 8-9 BCF/D currently. He felt inadequate take-away infrastructure would consequently drive the price at the local Waha hub to $1 per Million Cubic Feet. American natural gas is likely to remain among the world’s cheapest.

Water disposal came up in some discussions, and with volumes of produced water (i.e. water that comes out of the ground with the oil) in the Permian running at 4X the amount of crude output, treatment and disposal is providing additional infrastructure opportunities. Several firms were considering investments in this area.

Plains All American (PAGP/PAA) management was surprisingly defensive when asked about their simplification plans. They feigned surprise at the question (perhaps out of boredom) and suggested to one investor that perhaps he didn’t fully understand their structure. What’s really hard to understand is how the biggest crude oil pipeline operator in the Permian isn’t generating better results when record oil production is exceeding take-away pipeline capacity.

This has caused the Midland-Cushing differential to widen to $15 per barrel recently, far above the $2-3 pipeline tariff between the two hubs (see Dwindling Pipeline Capacity Causes FOMO). It should be a huge win for PAGP, whose investors holds the stock for precisely this scenario. But earlier 2016-17 mis-steps in Supply and Logistics caused PAGP to hedge 2018 basis risk far more conservatively, largely missing out on today’s excess demand for pipeline capacity. At still approximately 60% below their 2013 IPO price, PAGP’s stock reflects the need for better execution by management.

CEQP continues to execute well and met with many happy investors given the stock’s climb over the past couple of years. Meetings with Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP) were typically reassuring. Neither sees the need to convert from their MLP structure.

Enlink (ENLC/ENLK) Chairman Barry Davis described how they were emulating parent company Devon Energy’s (DVN) investment in IT to manage their operations. DVN has a single Data Control Center that remotely monitors all their activities. ENLC has created a task force to find similar opportunities to automate.

“Refracs” (when today’s new technology is applied to a previously fracked well) are delivering some impressive results for DVN in the Barnett shale for around $600K per well. But as in the past, ENLC will benefit as DVN sheds those assets in a region that they don’t deem strategic, to others willing to invest the time and capital. Nonetheless, a play believed to be in decline continues to maintain flat production.

Cheniere (LNG) explained how, in signing up customers for their next export facility, they can guarantee capacity from Sabine Pass as a stop-gap. Producers are sometimes unwilling to make a binding commitment to use new infrastructure when they’re unsure it’ll get built. LNG’s early-mover advantage allows them to guarantee capacity on Train 3 to producers who sign up for yet-to-be-built Train 6, which makes it easier to get customer commitments.

The industry’s fundamentals are good but complaints were heard that questions of structure continue to dominate. Many feel the MLP-only indices are losing relevance, and unanswered questions linger over the future of MLP-dedicated funds such as the Alerian MLP ETF (AMLP) and many mutual funds, since they face a shrinking number of MLPs to hold (see The Alerian Problem).

Next year REITs will apparently be added to the conference, which is relocating to Las Vegas. The conference organizers grasp the need for a broader approach.

We are long CEQP, ENB, ENLC, KMI, LNG, PAGP and WMB. We are short AMLP.

On the University of Texas website is a documentary titled Gift from the Earth: Natural Gas. It describes the construction of a pipeline to transport natural gas from Texas to population centers on the east coast, as far away as New York City. The pipeline was built by the Transcontinental Gas Company (Transco), and the documentary is from the 1950s.

Today, Transco has grown into America’s largest natural gas pipeline network. Since 1995 it’s been owned by Williams Partners (WPZ). With some justification, WPZ management describes it as irreplaceable – the cost to acquire the land and easement rights combined with the infrastructure itself would run into the tens of $Billions. WPZ is 6.6% of the Alerian MLP Index (AMZ) and 8.1% of the Alerian MLP Infrastructure Index (AMZI). It will soon be leaving.

Williams Companies (WMB) is WPZ’s corporate parent. They concluded that the advantages of having an MLP had diminished, and that their business will grow faster by rolling up the remaining publicly held units of WPZ (WMB already owns 74%) into the parent. Oneok Inc. (OKE), which absorbed its MLP last year, has an Enterprise Value/EBITDA multiple of 15-16X, a valuation WMB must feel is attainable from its present 11-12X.

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MLPs retained their tax-free status through last year’s tax reform. The problem is that the investor base remains frustratingly narrow. Those who face tax hurdles in buying MLPs include tax-exempt U.S. institutions and non-U.S. buyers, together a substantial percentage of U.S. equity holders. Most individuals are put off by the K-1s rather than 1099s for tax reporting. That leaves older, wealthy Americans whose accountants prepare their tax returns as the main source of equity capital.

Given their dependence on a fairly limited set of buyers, you might think MLPs would have treated them better. These holders were attracted by high, reliable tax-deferred payouts combined with modest growth. The Shale Revolution created new business opportunities that raised leverage, leading to slashed distributions (over 50 so far), and simplifications that come with a tax bill. Betrayed, these older, wealthy Americans now regard with skepticism MLP yields that are historically high, thereby raising the cost of equity capital for the sector.

Having destroyed their original buyers’ appetite, many companies have concluded that they need access to all the global equity investors, which requires being a corporation. On the same day that WMB announced their roll-up transaction, Enbridge Inc (ENB) made a similar move with their four sponsored vehicles, including MLPs Spectra Energy Partners (SEP) and Enbridge Energy Partners (EEP).

Uncertainty over FERC policy (see FERC Ruling Pushes Pipelines Out of MLPs) has also weighed on the sector, prompting some considering incorporation to move ahead.  WMB and ENB are the most recent in a steady stream of companies abandoning the MLP structure. In the past couple of months three other MLPs have made similar announcements, representing in aggregate 13.3% of AMZ (benchmark for numerous funds) and 15.5% of AMZI (benchmark for the Alerian MLP ETF, AMLP) which, absent further changes, will drop from 26 constituents today to 21.

This need not matter for direct holders. If your MLP is absorbed by its corporate parent, your MLP units are swapped for corporate equity securities. The assets are still there. In a now familiar routine, as they part with their WPZ units, WPZ holders will receive a tax bill for deferred income tax as well as a dividend cut (since WMB’s $1.36 dividend multiplied by the 1.494 exchange ratio is $2.03, 17% lower than WPZ’s current $2.46 distribution). It’s WPZ’s third cut in the last four years, so they must be getting used to it. Meanwhile, WMB will create a tax shield for itself through a stepped up cost basis on the acquired WPZ assets, making it 2024 before they’ll be a cash tax payer. This common benefit first drew attention when used four years ago (see The Tax Story Behind Kinder Morgan’s Big Transaction).

The new WMB will finance its growth with asset sales and reinvested profits while reducing leverage. They expect 10-15% annual dividend growth. It’s generally all good for WMB investors. But for many, the bigger story continues to be the impact of a steadily shrinking MLP universe on MLP-dedicated mutual funds and ETFs. AMLP and many MLP mutual funds now combine a tax-burdened corporate structure (see AMLP’s Tax Bondage) with a shrinking opportunity set that will soon exclude America’s biggest natural gas pipeline network. The problem has been growing (see Are MLPs Going Away? and The Alerian Problem).

In an amusing twist, during WMB’s investor day one analyst asked whether they’d considered maintaining Transco’s ownership within an MLP by shifting it into a blocker corporation. This is similar to the structure used by tax-burdened funds such as AMLP. WMB CEO Alan Armstrong replied that the additional corporate tax liability rendered such a solution uneconomic through multiple layers of taxation. In other words, the structure by which AMLP holds WPZ is regarded as unworkable when considered by parent WMB.

The promoters of such poorly structured funds deny a problem, which leaves it to their investors to do their own homework. Fewer MLPs may even cause investors to exit such funds in search of more diversified exposure, depressing prices. ENB’s press release referred to, “…the continuing deterioration in the MLP equity marketplace.”  Their presentation asserts that, “Sponsored vehicles are ineffective and unreliable standalone financing vehicles.” MLPs aren’t going away, but they’re clearly not an attractive choice for companies in need of equity capital to grow.

The problem is one of structure, not fundamentals. U.S. hydrocarbon output is hitting new records, in some cases leaving the infrastructure struggling to keep up (see Dwindling Pipeline Capacity Causes FOMO). The appeal of broad-based, tax-efficient energy infrastructure using mostly corporations is strong.

We are invested in ENB, KMI and WMB. We are short AMLP

Reports on the Shale Revolution rarely discuss its impact on U.S. energy security, but with little fanfare it’s affording the U.S. greater geopolitical flexibility. The Administration’s decision last week to withdraw from the Iran nuclear deal was made without significant regard to the ensuing reduction in Iranian oil exports. Successive U.S. presidents back to Richard Nixon have called for U.S. energy independence without being able to achieve it. The U.S. is already energy independent on a BTU-equivalent basis (i.e. we produce more energy than we consume in aggregate). We became natural gas independent last year as Liquefied Natural Gas (LNG) exports ramped up. We’ve been a net exporter of ethane since 2014, and of propane since 2011.

But when a President calls for energy independence – or even energy dominance – he means crude oil. Here, the story is almost as good. In August 2006, net imports of crude oil and petroleum products hit 13.4 Million Barrels per Day (MMB/D). Today that figure is below 3 MMB/D. Even when the U.S. does become a net exporter we’ll still be importing the sour, heavy crude favored by domestic refineries while exporting the lighter grades that are increasingly produced from shale.

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Furthermore, our imports are increasingly from friendly countries. Canadian exports to the U.S. have been rising for years and are currently 4.3MMB/D, while OPEC imports have dropped by 50% in the past decade, to below 3 MMB/D. U.S. imports from Iran ceased entirely during the 1980 hostage crisis and have never recovered. In fact, total trade in goods between the U.S. and Iran was an inconsequential $200MM last year. While Iran is of no economic value to the U.S., the likely imposition of sanctions will constrain Iran’s exports to other countries. The recent rally in crude is in part attributed to fears of less Iranian crude on the global market – they currently produce 3.8MMB/D.

But the U.S. is far less vulnerable to a price spike than in the past. Oil-producing states such as Texas, North Dakota, New Mexico and Oklahoma will welcome the economic boost. Treasury secretary Steve Mnuchin was reported to have discussed with U.S. oil companies ways in which they could raise output, but any decisions are likely to be commercially driven. The Federal government was of little help to the industry during the 2014-16 oil price collapse, and has limited near term ability to influence production levels.

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U.S. crude output is responding. Rising prices and falling break-evens are improving profitability, driving output to 10.7MMB/D. Just a year ago, the U.S. Energy Information Agency (EIA) was forecasting 2018 output of 9.9MMB/D, likely 1 MMB/D too low. They now expect 2019 to average 11.9MMB/D. Although growing strongly, U.S. output is insufficient to meet new global demand (~1.5MMB/D) plus offset depletion of existing oil fields (estimated 3-4 MMB/D). OPEC is showing surprising discipline in sticking to their supply agreement. Iran’s exports will likely drop and Venezuela’s production is in freefall. It’s not hard to make a bullish case for oil, and for U.S. companies involved in its production and transportation.

Infrastructure constraints are appearing (see Dwindling Pipeline Capacity Causes FOMO), most visibly in the Midland-Houston crude spread which recently exceeded $15. Wellhead prices can suffer an additional discount of up to $8/bbl to adjust for trucking and shuttle pipeline transportation costs to Midland.  Differentials are far in excess of the cost of pipeline transport, because pipelines leaving the Permian in west Texas are full. There are reports that the rail network is clogged with trainloads of fracking sand entering the region, while trucks and truckers are in short supply. Although the logistical challenges offer profit opportunities for the owners of energy infrastructure, in the near term crude output growth may be constrained.

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It’s even more acute for Permian natural gas production, which is an associated by-product of crude oil output. On Energy Transfer’s earnings call COO Marshall McCrea predicted occasional days of no bid for natural gas at the Waha hub, a collection point for Permian gas. That’ll leave drillers contemplating flaring of natural gas or shutting in otherwise profitable wells while the infrastructure catches up.

In March, before today’s pipeline constraints had affected price differentials, Magellan Midstream Partners (MMP) dropped plans to add a pipeline that would have moved 350,000 Barrels per Day of crude across Texas, because not enough producers would guarantee to use it. Pioneer Natural Resources (PXD) CEO Scott Sheffield warned the industry, ““Oil has a problem late this year and also in 2020.” He added, “It will teach these producers a lesson that they better sign up.”

In other words, insufficient pipeline capacity is in part down to the earlier reluctance of producers to commit, which discouraged the development of infrastructure that would have been in use today. Smaller firms, often privately owned, are more vulnerable than large ones. PXD has firm transportation contracts in place for their increasing production of oil and gas, a point they highlighted in their recent earnings presentation.

One analyst at Rystad Energy blamed energy infrastructure companies for the bottlenecks, saying they had, “…really missed their opportunity when there was a need for investment in new capacity.” In fact, the multi-year travails of MLPs can be traced to the relentless pursuit of growth projects by management teams at the expense of stable distributions (see Will MLP Distributions Pay Off?). When capital was available and customer commitments forthcoming, new infrastructure was built. Oil producers have surprised many, including themselves, at the volume growth efficiencies have made possible. PXD reports Permian breakevens for producers at under $30 per barrel, and in their 1Q18 earnings report show their own costs at around $19 per barrel.

Thanks to the Shale Revolution, U.S. geopolitical decisions are benefiting from more strategic flexibility than in the past.

We are invested in Energy Transfer Equity (ETE), General Partner of ETP, and MMP

Last week was a busy week of earnings reports for many sectors, including energy infrastructure. Growing energy sector profitability is feeding through to higher returns to investors. Over the past month the S&P Energy Sector ETF (XLE) has outperformed the S&P by over 9%. RBN Energy has a good blog post (see Better – E&P Profits Appear Ready To Take Off This Year After Turning A Corner In 2017), highlighting that the 2017 impairments are unlikely to be repeated and that higher oil prices will drive improved operating margins.

Enterprise Products Partners (EPD) reported 1Q18 EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of almost $1.7BN, 11.5% ahead of consensus. That was a significant beat for such a large, stable business as every segment did better than expected. EPD has a premier position on the Gulf Coast and is a leading exporter of U.S petroleum liquids.  On the call, CEO Jim Teague highlighted the value of midstream companies in getting product to the global market. “The name of the game for U.S. production is exports, exports, exports, exports, of crude oil, natural gas, ethane, LPG, petrochemicals and refined products.”  Last year EPD trimmed its forecast distribution growth in order to redirect more cashflows into growth projects. Income seeking investors were underwhelmed, but it simply reflected EPD’s response to the changing MLP business model.

1Q18 earnings reported by Oneok (OKE) beat expectations by 4%, driven by strength in their Natural Gas Liquids segment in the SCOOP and STACK play in Oklahoma. Pembina (PPL) announced a 19% year-on-year dividend increase as their Veresen acquisition and assets recently placed into service powered EBITDA growth. Targa Resources (TRGP) reported a solid quarter and positive outlook.  They are the leader in providing gathering and processing in the Permian Basin, but even more interesting was the volume growth they saw elsewhere, in North Dakota and South Texas. Tallgrass Energy Partners (TEP) reported on their earnings call increasing throughput on their Pony Express crude pipeline that links the Bakken in North Dakota to Cushing, OK. 1Q18 volumes averaged 290 thousand barrels per day (MB/D), up by 22MB/D on 4Q17, and are expected to reach 350MB/D this month. This shows that it’s not just Permian crude output that is growing, with U.S. production reaching 10.6MMB/D. Record earnings and volumes were reported by a good number of names.

Most dramatically, Cheniere Energy (LNG) announced consolidated EBITDA of $907MM, up 88% on a year ago and 46% ahead of expectations. They raised full year guidance by 14%. Surging demand for U.S. exports of Liquified Natural Gas underpin the outlook. Higher crude prices are also improving the competitive position of U.S. exports since global natural gas pricing is often linked to crude oil while U.S. domestic gas prices remain among the lowest in the world.

Energy infrastructure businesses do better when their customers are thriving. Growing oil and gas production is creating tightness in some of the support functions. We recently highlighted the Midland-Houston spread for crude oil, which should normally be limited by the $2-3 pipeline tariff to move crude from the Permian wellhead to customers on the Gulf Coast (see Dwindling Pipeline Capacity Causes FOMO). Limited pipeline capacity had caused the differential to increase to over $6, as producers were forced to utilize more expensive rail or truck transportation. Last week the spread reached $12, beyond the cost of rail transportation and therefore indicating greater use of trucks.

The losers are oil producers without contracted pipeline take-away capacity. The pipeline industry often complains about “freeloaders”; pipelines are built once enough capacity has been contracted out to meet required return thresholds. Oil and gas producers who don’t make those early commitments can still access the pipeline once it’s built. They benefit from the support of their peers who underwrote the infrastructure development. But when pipeline capacity is tight, these “walk-up” customers have to pay market rates, which rise. Plains All American (PAA) will announce earnings on Tuesday, and as the biggest crude oil pipeline operator in the Permian, their comments on demand for takeaway capacity will be especially interesting.

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Not everything was good. Marathon Petroleum (MPC) acquired Andeavor, orphaning MLP Andeavor Logistics (ANDX). We highlighted in last week’s blog that corporate parent TransCanada (TRP) had said their MLP, TC Pipelines (TCP), was no longer viable as a funding vehicle, rendering them of little use to TRP. Subsequently, TCP slashed their distribution by 35%. The recent FERC ruling was the cause. Spectra Energy (SEP) and Enbridge Energy Partners (EEP) were similarly weak as investors contemplated their “orphan” status. One subscriber asked us if he should avoid MLPs entirely that have a separate General Partner (GP), given recent developments. As regular readers know, we only hold MLPs that have no GP, to avoid just the sort of issue faced by TCP investors.

Williams Companies (WMB) set new volume records for gas on its TransCo system, but offered little new regarding a potential combination with their MLP Williams Partners (WPZ). Their Analyst Day later this month is expected to offer an update. WPZ investors face the risk that a combination with WMB will trigger a tax bill for deferred income.

Broad energy infrastructure as defined by the American Energy Independence Index continues to outperform the narrower Alerian MLP Index (AMZ), a trend set in motion by the FERC ruling in March. AMZ remains below its pre-FERC announcement level. Although MLPs retain an important tax advantage over corporate ownership of energy infrastructure assets, the several dozen distribution cuts by MLPs since 2014, as well as unwelcome simplification transactions, have clearly soured their traditional investor base. MLPs are evolving towards more internally-financed growth, which is for now impeding distribution growth.

On Tuesday, we’ll be ringing the NYSE closing bell to celebrate the recent launch of our ETF. Check us out on CNBC at 4pm.

We are invested in EPD, LNG, MPC, OKE, PPL, TRGP, TEGP (GP of TEP) and WMB

In recent weeks there’s been growing discussion about the future of  MLPs (see Are MLPs Going Away?). Although the prospects for U.S. energy infrastructure are very good, the need for growth capital has exposed the limitations of the MLP investor base. Not everyone agrees. Stacey Morris of Alerian provided a thoughtful assessment (see Are MLPs Really Disappearing?), and concluded that MLPs would remain the dominant corporate form in the sector.

Two external factors weighing on sentiment have been tax reform and the FERC (Federal Energy Regulatory Commission) ruling. Tax reform’s impact was modest; a lower corporate tax rate reduces the competitive advantage of an MLP over a corporation, but the tax rate on recapture of income previously deferred was improved. The FERC ruling is potentially a long run problem for some businesses.

Although MLPs don’t pay tax, they had included taxes paid by their equity investors in calculating costs for certain contracts. It’s an odd concept, to include as an expense a cost you don’t incur, and a successful court challenge by United Airlines led to the change. The subsequent FERC announcement briefly led to a 10% drop in MLP prices on March 15th, highlighting confusion as well as the shallow conviction of some holders. While initially limited to certain interstate natural gas pipelines, it will in time also apply to other liquids lines. It’s narrow in scope but still a mild negative for a few names. It’s likely that the same assets held by a corporation rather than an MLP wouldn’t be as affected, which will cause some firms to consider changing their form of ownership.

We’re long-time MLP investors. While at JPMorgan, the private equity fund I ran seeded Alerian’s offshore MLP hedge fund in 2005. Tax-deferred, stable, high yields uncorrelated with commodity prices attracted many. The re-emergence of the U.S. as a significant energy producer changed that. Before the Shale Revolution, we consumed roughly the same quantities of energy from the same parts of the country every year. The need for new infrastructure was limited. Consequently, MLPs could pay out 90% or more of their Distributable Cash Flow (DCF) to the older, wealthy, K-1 tolerant investors who were the main buyers.

This financing model wasn’t able to support the need for growth capital to connect new sources of oil and gas with customers: crude oil from North Dakota; natural gas from Pennsylvania and Ohio; sharply increasing volumes of crude from the Permian Basin in west Texas. MLPs tried maintaining distributions while issuing increasing amounts of equity and debt, but it didn’t work. Kinder Morgan (KMI) went first in 2014, rolling up three public entities into their corporate parent, simplifying from four traded entities to one (see What Kinder Morgan Tells Us About MLPs). They chose to pursue their backlog of growth projects rather than maintain payouts.

Corporations Targa Resources (TRGP), Oneok (OKE), and SemGroup (SEMG) similarly acquired their MLPs.  This maintained the dividends paid by the parent which also gained a tax shield, but as with Kinder Morgan, their MLP unitholders saw distributions cut in a taxable transaction.  An MLP investor base that had been promised stable and tax deferred income got neither.  Plains All American (PAA) and Williams Partners (WPZ) both cut payouts as they simplified their structures.  When NuStar (NS) CEO Brad Barron explained recently why they were combining their General Partner with their MLP, he cited 54 MLP distribution cuts since 2014 (NS made it 55).

One consequence of reducing payouts has been the alienation of the traditional MLP investor: the older, wealthy, taxable American. The covenant of stable distributions has been broken. Although in many cases it’s been replaced with the promise of future growth, that’s not interesting to an income-seeking investor. Today’s 8.24% yield on the Alerian MLP Index represents an investment opportunity, but it also represents a financing failure for MLPs. Because investors don’t trust the yield, the cost of equity for MLPs is higher than it should be.

MLP managements are speaking out. Brad Barron recently said, “…MLPs with low coverage and high leverage have been effectively shut out of the MLP equity markets, and even MLPs perceived as ‘healthy’ have found it increasingly difficult to issue common equity.” He followed up with, “…the exodus of MLP retail investors, and the nearly frozen equity markets- have called the long-term viability of the MLP model into question.”

A couple of weeks ago Tallgrass (TEGP) CEO David Dehaemers commented to us on why they’d abandoned the MLP model only five years after taking Tallgrass Partners (TEP) public (see A Chat with Tallgrass CEO David Dehaemers). John Chandler, CFO of Williams Companies (WMB) fielded questions on possible plans for their MLP Williams Partners (WPZ). On Friday’s earnings call Transcanada (TRP) said financing assets at their MLP, TC Pipelines (TCP) was no longer viable.

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MLPs are converting to corporations because the MLP structure has turned out to be a poor source of growth capital. The Shale Revolution requires financing to build new infrastructure, and income seeking investors aren’t that keen to provide it.

In recent years MLP-dedicated funds have developed to provide MLP-exposure without the K-1 headache to mutual fund and ETF buyers. Such funds labor under a corporate tax liability (see AMLP’s Tax Bondage), incurring an additional cost which can be substantial in a strong market. In 2013-14 when sector returns were very good, taxes and other expenses ate up a third of returns for some funds, and on top of that holders still faced their own investment tax bill.

Moreover, we know from many, regular conversations that few financial advisors using such vehicles appreciate the tax drag their fund choice incurs. Mutual funds and ETFs don’t pay tax, so it’s not an obvious consideration – unless they’re MLP funds. The sharp drop on March 15^th following the FERC ruling betrayed the narrowness of the investor base.

However, MLPs are certainly not going to disappear entirely. To MLPs that don’t need external growth capital, such as Enterprise Products (EPD) or Magellan Midstream (MMP), the depressed values of MLPs doesn’t matter much. Their owners can continue to enjoy the tax efficiencies, which include no corporate tax and deferral of income tax on the majority of distributions. But for most companies, the point of a public listing is access to capital. Traditional income seeking investors and tax-burdened MLP-dedicated funds are the two main investor groups – not a very reliable set of buyers on which a CFO might rely.

A shrinking MLP universe won’t hurt Alerian; as Stacey Morris notes, “We’re an indexing firm. We’re not in the business of giving investment advice.” Alerian publishes plenty of indices, and can add more. But holders of tax-burdened, MLP-dedicated funds have an additional risk to consider as MLPs incorporate, and they could use some advice. An analyst at East Daley recently warned that the FERC ruling may cause some firms to drop the MLP structure. Williams Partners (WPZ), Plains All American (PAA), EQT Midstream Partners (EQM), Antero Midstream Partners (AM), Spectra Energy Partners (SEP), TC Pipelines (TCP) and Enbridge Energy Partners (EEP) may all ultimately be rolled up into corporate parents.

In addition, the 12.6% yield on Energy Transfer Partners (ETP) is a powerful inducement to find an altered structure that attracts more investors. Without these, what’s left will represent an even narrower exposure to energy infrastructure than it does today. MLP-dedicated fund investors should be wary (see The Alerian Problem). Fewer names will either lead to more concentrated portfolios of less liquid securities or a highly disruptive shift to a broader index. Restricting your energy infrastructure investments to MLP-dedicated funds might be too narrow. Like the disappearing Cheshire cat in Alice in Wonderland, you may be left to contemplate just a smile.

We are invested in ENB, EQGP, ETE, KMI, NSH, OKE, PAGP, SEMG, TEGP, TRGP, TRP and WMB

FOMO (Fear of Missing Out) hasn’t been much of a problem for energy infrastructure investors over the past year or so. Feelings of WAIL (Why Am I Long?) and (ahem) WTF have been far more common. So the recent rally in the sector has led many investors to enquire why. Earnings only began to be released on Wednesday when Kinder Morgan (KMI) announced a 60% dividend increase and $500MM of stock repurchases since December. Although the dividend hike was expected, the stock nonetheless gained ground. KMI’s 2014 simplification, when they moved from four public entities to one, heralded the conflict between the old and new business model.

Shale Revolution-induced growth opportunities pursued by management collided with the desire of income-seeking investors for steadily growing cashflows (see Will MLP Distribution Cuts Pay Off?). An adverse tax outcome and two distribution cuts followed for original investors in Kinder Morgan Partners. MLP simplification became synonymous with abuse of your core investors, at least until Tallgrass (TEGP and TEP) recently managed to execute one that was well received.

Nonetheless, the persistent high yields on MLPs betray the skepticism of their traditional investor base of older, wealthy Americans. Last year Oneok (OKE) combined with its MLP Oneok Partners, inflicting a KMP-type tax bill on long-time MLP holders. One friend of mine held its predecessor Northern Border Partners from the 1990s, and received an unexpected tax bill on deferred income recapture that was timed to suit OKE, not him. Such investors are not about to commit new money to MLPs. This is the problem facing MLPs but not corporations. MLPs are cheap, but they’ve alienated their core investor base, which is already narrow. This is why investors need to look for broad energy infrastructure exposure including corporations, and not be limited to MLPs (see The American Energy Independence Index). KMI’s $500MM stock buyback would not have happened when they were structured as an MLP.

Substantive developments to explain the rally are few, although Saudi comments favoring $80 oil have helped. Technical analysts have noted that energy infrastructure shows signs of bottoming, something not heard since 2016. Energy stocks are gaining more airtime on CNBC. More tangibly, on Wednesday, the WSJ’s Is the U.S. Shale Boom Hitting a Bottleneck gathered substantial attention by suggesting, “…the U.S. shale boom appears to be choking on its own growth…”

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The article included a chart (reproduced here) that is a true object of beauty to any pipeline owner. The problem of sharply growing crude oil production in the Permian is testing the limits of take-away pipeline capacity.  Crude oil located in Midland is usually worth less than in Houston, where it’s conveniently near refineries and export facilities. The price difference is typically going to be limited by the cost of pipeline transportation, which is around $2-3 per barrel. Permian output is currently 3.1 Million Barrels per Day (MMB/D), with pipeline take-away capacity of 3.2MMB/D.

The price differential has widened beyond the pipeline tariff because not all the crude wishing to travel to Houston can get in a pipeline. Some is moving by rail (around $8 per barrel) while truckers charge from $10 to as high as $15-20 (truck drivers are in high demand in Texas).

This is a problem for Permian oil producers, since the increased cost of getting their product to market eats into margins. However, it’s a profit opportunity for pipeline owners, since the portion of their capacity that is sold at market rates is now much more profitable. Bottlenecks are good for infrastructure owners. They make money from regional price differentials in excess of the costs of storage and transportation. When Plains All American (PAGP) cut their distribution last year, they blamed it on a collapse in their Supply and Logistics division as regional price differentials were boringly close to transportation costs, minimizing arbitrage opportunities.

Some additional pipeline capacity can be squeezed out through more efficient utilization. Drag reducing agents (millions of tiny polymer string segments) can be mixed with crude which, through the magic of hydrodynamics, reduce turbulence as the liquid travels. But meaningful new capacity isn’t expected until 2H19, which on current trends should maintain the steep Midland-Houston discount and support continued higher pipeline tariffs. Among the beneficiaries of this are PAGP, Energy Transfer Equity (ETE) and Enterprise Products Partners (EPD).

We are invested in EPD, ETE, KMI, PAGP and TEGP

Continuing our series of interviews with senior energy executives, we recently had the opportunity to catch up with David Dehaemers, President and CEO of Tallgrass Energy GP (TEGP). The theme of our discussions was: How has the Shale Revolution changed your business? Behind the miserable recent performance of energy infrastructure securities lies the most fantastic American success story. U.S. oil and gas production have significantly altered global markets, culminating with OPEC’s 2016 about-face on low oil prices (see OPEC Blinks).

OPEC  tried to bankrupt the U.S. Shale industry and failed, because the American capitalist system showed its flexibility. Innovation and productivity improvements substantially lowered break-evens for U.S. producers. Since then, a constant source of investor frustration has come from trying to reconcile booming domestic production of hydrocarbons with the languishing stock prices of the businesses that gather, process, transport and store them.

The Shale Revolution has impacted Tallgrass as much as any business. CEO Dehaemers noted that their Pony Express crude oil pipeline that runs from Wyoming to Cushing, OK probably wouldn’t exist without it. Even more striking has been the change to Rockies Express (REX), the natural gas pipeline originally built to supply Rocky Mountain gas to Ohio and beyond. As Marcellus Shale production turned the region from an importer to an exporter of natural gas, REX’s prospects, especially at its eastern sector, dimmed.

So Tallgrass reversed the flow of the pipeline, allowing Pennsylvania gas to supply Chicago and the midwest. In the process they created a “header” system that, by running in both directions across the northern U.S. can link up with north-south pipelines to add further supply routes. We’ve written about this in the past (see Tallgrass Energy is the Right Kind of MLP).

As well as the impact on Pony Express and REX noted above, Dehaemers commented that the Shale Revolution had allowed better use of their existing assets. Like all midstream businesses Tallgrass works closely with their producer customers, seeking to ensure that infrastructure capacity is synchronized with growing oil and gas production. The trend is towards fewer vertical wells as drillers employ multi-pads (“mega-pads”), often consisting of up to 16 wells within 400 yards of one another, each with multiple horizontal wells branching off. This is a significant source of the dramatic productivity improvements that many Exploration and Production (E&P) companies have enjoyed in recent years.

Tallgrass recently announced the combination of their General Partner, TEGP, with their MLP Tallgrass Energy Partners (TEP). Several of their peers have executed “simplifications”, beginning with Kinder Morgan in 2014. Generally they’ve been disappointing, resulting in a distribution cut for MLP holders and sometimes an unexpected tax bill if the combination is determined to be a sale of the assets. A lower stock price has duly followed, and simplification has come to mean loss of value for investors. Unusually, Tallgrass managed to pull off their GP/MLP combination without a distribution cut, and although TEP investors will face a tax bill it won’t be much as the income tax deferral only dates back to the 2013 IPO. Few such simplifications have been well received by the market, but this one was thoughtfully done and investor response was positive.

We were interested to learn why Dehaemers had decided the MLP structure was no longer appropriate, given that only five years earlier they’d floated TEP as a publicly traded MLP. He felt that some businesses had been launched as MLPs without the stable underlying cashflows that the investor base typically seeks. He also felt that K-1s were a bigger impediment than generally thought. We believe a still underappreciated fact is that older, wealthy Americans are the main source of MLP demand. Their distributions have been cut as cashflows have been redirected to reduce imprudent leverage and finance growth projects. The consequent 30% drop in distributions (as seen on Alerian-linked products, see Will MLP Distribution Cuts Pay Off?) renders high yields less compelling. David generally agreed with this assessment, noting that some other firms had unfortunately “gotten over their skis” with more risk than was appropriate. We’d add here that Tallgrass has been a welcome exception, having delivered consistently strong annual distribution growth (32% at TEP and 55% at TEGP since its 2015 IPO).

Although the MLP structure retains its advantageous tax treatment compared with corporate ownership, Dehaemers felt that the sector was unlikely to enjoy a resurgence as a substantial source of capital anytime soon. Incentive Distribution Rights (IDRs), whereby the GP earns preferential economics for running the MLP, have been widely criticized. We’ve long thought that this issue is overplayed, as investors in hedge funds and private equity routinely accept preferential economics for their fund managers. However, David noted that social media pays far less attention to these private vehicles than to publicly traded securities, and he felt that growing IDR opposition was a factor.

We were curious to know whether Dehaemers thought Tallgrass Energy (TGE), the entity resulting from the combination of TGP and TEP, would be included in the Alerian Index. Given the shrinking number of MLP names, the index is becoming less representative of energy infrastructure (see The Alerian Problem). TGE is unique in that it’s a single partnership electing to be taxed as a corporation with no publicly traded affiliate, so it’s unclear whether Alerian’s current rules would include it. Dehaemers had not given this much thought, perhaps because the point of the combination is to access a broader set of investors than those interested in MLPs.

Tallgrass is a company that we expect to benefit from American Energy Independence, and it’s included in our similarly named index.

Lastly, we noted the high 9.6% yield on TEP (TGE after the combination), and asked how they think about the division of cash between investor returns and paying for new projects. Dehaemers felt the 1.2X distribution coverage should encourage buyers to drive the yield down, and combined with mid-to-high single digit % growth TEP is an attractive investment. We agree, and will continue to follow Tallgrass’s progress with interest.

We are invested in TEGP

On Tuesday, May 8th we’ll be ringing the 4pm closing bell at NYSE in recognition of our recently launched ETF. We’ll post further updates on our blog. 

Last week’s blog, The Alerian Problem, drew a bigger than average response. We reposted it on Seeking Alpha where you can see all the comments from readers. More interestingly, it led to a useful dialogue with sell-side analysts and investors.

The shift from MLP to corporate ownership of energy infrastructure is becoming widely acknowledged. Since the FERC announcement in early March disallowing MLPs from including imputed tax expense in setting certain tariffs, corporates have handily outperformed MLPs. Although the near-term impact is likely minimal, the ruling will eventually impact some liquids pipelines as well as natural gas. It does seem likely to limit dropdowns of eligible assets from corporate owners to their MLP as well as hasten conversions to corporate ownership.

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One analyst we’ve spoken to wrote of, “…strong evidence of the potential catalytic response available to partnerships that could convert…” from MLP to corporate ownership, citing the jump in Viper Energy Partners (VNOM) and Tallgrass (TEGP/TEP) since each abandoned the MLP structure.

The Alerian Problem, which specifically asks what MLP-dedicated mutual funds and ETFs will do as their index shrinks, has no easy answers. Weak relative MLP performance will not help flows which have in any case been flat for such funds, and redemptions will continue to weigh on prices, encouraging additional MLP->Corporate conversions.

MLP funds can continue to hold names that have converted to corporate status, and in conversations with investors we understand some have indicated they may do this. However, since such funds are already burdened with paying corporate taxes (see AMLP’s Tax Bondage), holding tax-paying corporate equities in a tax-paying corporate fund structure is going to strike many investors as absurd.

Therefore, such funds will be left with a choice between picking amongst a shrinking pool of names, or the nuclear option of switching indices since they’d then dump their MLPs. It’s probably best not to be the last tax-burdened MLP fund to make such a switch, nor the last fund investor to redeem from such a prospect.

One investor we spoke to last week found this sufficient reason to exit his remaining tax-burdened MLP funds in favor of a more efficient, RIC-compliant structure. In a sign other investors have already begun doing the same, the Alerian MLP Fund (AMLP) has seen its AUM drop from $10.3BN at year-end to $8.6BN, a 17% drop and substantially worse than its YTD performance of -11.6%.

On a positive note, the recent ratcheting up of trade tensions has given investors a reason to own energy stocks. Tariffs on crude oil or Liquified Natural Gas are hard to imagine and probably impractical. Since Gary Cohn’s March 7th resignation signaling a more confrontational approach was ascendant on such issues, the S&P Energy sector has outperformed the broader market by 5%.

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We are short AMLP