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

In 2005, when I was providing seed capital to emerging hedge funds at JPMorgan, we met with Alerian’s founder Gabriel Hammond. “Gabe” knew a great deal about Master Limited Partnerships, and he was convinced that the sector needed an index in order to grow. He was right, and Alerian’s index became the most widely used benchmark for MLPs. We seeded Alerian Capital Management’s offshore hedge fund.

Back then, MLPs were synonymous with energy infrastructure. To invest in one was to invest in the other. But as regular readers know, much has changed since then. MLPs are now a shrinking subset of energy infrastructure. The Shale Revolution created the need for growth capital to build new pipelines, because crude oil hadn’t previously been sourced in North Dakota, nor natural gas in Pennsylvania. The MLP’s promise to pay investors 90% of Distributable Cash Flow (DCF) came into conflict with their desire to invest in new projects. The older, wealthy Americans who owned MLPs were there for the regular income. Foregoing some of today’s distributions in exchange for the promise of higher future returns wasn’t appealing, and MLPs turned out to be a poor source of growth capital. MLPs began “simplifying”, in many cases becoming regular corporations where payout ratios are far less than 90% and investors are global. In short, the older, wealthy American turned out to be the wrong type of investor for midstream energy infrastructure’s response to the Shale Revolution. MLPs were no longer equivalent to energy infrastructure.

We’ve watched and participated in this evolution as investors. It’s an ongoing source of considerable frustration to many that the energy sector has performed so poorly when the fundamentals appear so promising. The price of oil peaked along with sentiment in 2014, since when the S&P Energy ETF (XLE) has dropped 18% while the broader S&P500 is up 52%. Volumes continue to grow, with crude oil, natural gas and its related liquids (such as ethane and propane) all reaching new records this year.

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The higher volumes will ultimately drive higher profits for the midstream infrastructure businesses that gather, process, transport and store them, although the alignment of production and stock returns is becoming an interminable wait. In the meantime, the vast majority of funds that specialize in energy infrastructure are dedicated MLP funds. They face a tax drag (see AMLP’s Tax Bondage), and a shrinking pool of names (see The Alerian Problem).

Corporations, not MLPs, control U.S. energy infrastructure. And yet, some of the biggest operators such Kinder Morgan (KMI, market cap $34BN), Oneok Inc (OKE, market cap $24BN), Williams Companies (WMB, market cap $21BN) or Cheniere Inc (LNG, market cap $13BN) don’t appear in the MLP-dedicated funds that, as a result, no longer represent a broad investment in energy infrastructure.

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The American Energy Independence Index (AEITR) constituents have a market cap of more than twice that of  the Alerian Index. The AEITR also includes General Partners (GPs), whose control of many MLPs provides them with preferential rights as well as being the investment of choice for most management teams (see MLPs and Hedge Funds Are More Alike Than You Think). The AEITR includes some Canadian names, since North America’s pipeline network crosses the border in numerous places and some significant elements of U.S. infrastructure are connected to their northern neighbor’s network.

The result is a far more complete representation of midstream infrastructure. The American Energy Independence Index represents the future, which increasingly is corporate ownership of assets, versus the outdated model limited to MLP ownership. For investors seeking to follow the Shale Revolution’s drive towards American Energy Independence, we believe it offers a superior way to participate.

We launched the index in November, and its associated ETF in December. We think because AEITR is more diversified, it has demonstrated 11% smaller average daily moves than the Alerian Index. Given Alerian’s shrinking pool of eligible MLP names and more concentrated sector exposure, we expect the American Energy Independence Index to continue exhibiting lower volatility.

What do you do if your fund’s index is shrinking? This is the dilemma that many retail investors in MLP-dedicated mutual funds and ETFs will be confronting in the months ahead.

The trend for MLPs to simplify by combining with their corporate General Partner (GP) is well established. The recent Federal Energy Regulatory Commission (FERC) ruling (see FERC Ruling Pushes Pipelines Out of MLPs) prompted us and other observers to conclude that this trend is likely to continue, if not accelerate (see Are MLP Going Away?). Last week Tallgrass Energy Partners (TEP) combined with its GP Tallgrass Energy GP (TEGP), the first such announcement since the FERC ruling on taxes and one of the few simplifications to result in a bounce in the stock price. TEP will drop out of the Alerian Index, reducing the number of constituents to 41. At the end of 2015 it stood at 50.

On Monday, oil driller Legacy Reserves LP (LGCY) announced they were converting from an MLP to a corporation, causing their stock to jump 11%. CEO Paul Horne clearly will not miss running an MLP. In the press release, he noted that, “…we look forward to stepping out from the dark cloud we have been under as an upstream MLP.” On Friday, Viper Energy Partners LP (VNOM) jumped 10% after electing to be taxed as a corporation. Simply by agreeing to be a taxpayer, thereby issuing 1099s instead of K-1s, they became more valuable. Their presentation noted, “VNOM will be uniquely positioned as a first-mover and leading public minerals yield vehicle without the limitations of an MLP.” These moves reflect the disdain investors have developed for the MLP structure, and the bigger ones contemplating their own conversion will have taken note.

The reduced corporate tax rate makes MLPs relatively less attractive. FERC’s elimination of imputed tax expense, although inconsequential in the near term, will affect cashflows for some interstate natural gas pipelines and, in a couple of years some liquids pipelines too. Moreover, MLP yields remain stubbornly high. They are attractively valued, but as such they represent an expensive source of equity capital for issuers. The older, wealthy American who is the typical MLP investor wants steady income. The shifting of cashflows to fund new infrastructure projects demanded by the Shale Revolution has alienated him (see Will MLP Distributions Pay Off?). All these factors are reducing the value of putting eligible assets in an MLP.

As a result, MLPs are less than half of the midstream energy infrastructure sector, and each MLP simplification further reduces their number. This need not matter much for a holder of individual MLPs. As your MLPs convert to corporations, your portfolio’s composition shifts as well. TEP investors will still own the same assets via Tallgrass Energy, LP (TGE), a corporation for tax purposes.

But if you’re invested in an MLP-dedicated fund, you and your fund manager face a problem. A shrinking Alerian MLP Index (AMZ) creates a dilemma for funds that are benchmarked to it. If they do nothing, the index (and therefore, the fund) will become steadily less representative of the sector, with fewer names and a smaller median market cap. Today, the median market cap of AMZ’s constituents is only $1.8BN, compared with $15BN for the broader American Energy Independence Index (AEITR). Not coincidentally, since the FERC announcement broader, corporate exposure to infrastructure has outperformed the MLP-dedicated Alerian index.

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To put this in perspective, the Alerian MLP ETF (AMLP), various tax-impaired mutual funds offered by Oppenheimer Steelpath, Goldman Sachs, Center Coast and Cushing, along with the JPMorgan Alerian MLP Index ETN hold a combined $24BN in MLPs linked to AMZ.  This is 14% of AMZ’s float-adjusted market cap. If these funds do nothing, tracking their index will shift them into more concentrated portfolios, or smaller names, or both.

Rather than fight against this tide, it might make sense for them to consider switching to a more representative index that better reflects energy infrastructure. However, like watching elephants dance, it’s unlikely to be elegant. If AMLP announced that it was substituting a different, broader index, that would immediately depress the prices of those MLPs that it would need to sell, hurting performance immediately. Actively managed mutual funds could implement portfolio shifts to a broader index over weeks or months, and although this might lessen the immediate market impact, it would introduce tracking error against both old and new benchmarks. It would likely be disruptive to their performance.

If all these funds sold 75% of their MLPs they could even claim to be RIC-compliant and no longer subject to the drag of corporate taxes. Unfortunately, that would require selling $BNs of MLPs, and the reason MLPs are converting to corporations is because MLP prices are depressed.

MLP-dedicated funds face an unenviable business decision, and they’re clearly best served by the status quo. Their best outcome is to delay changing their benchmark indefinitely, and hope to convince their retail investors that MLP-only funds remain a viable proposition. The risk for current and future holders is that the shrinking Alerian Index eventually forces them to change, which could be tumultuous. It might be one reason why net inflows to MLP-dedicated funds are flat since last Summer. In addition to the headwinds of corporate taxes (see AMLP’s Tax Bondage), you can add index uncertainty. It’s The Alerian Problem.

We are short AMLP

MLP investors have certainly seen their conviction tested of late. Poor stock performance was recently compounded by the Federal Energy Regulatory Commission’s (FERC) ruling on cost of service contracts earlier this month. Although MLPs don’t pay tax, interstate natural gas pipeline tariffs based on cost-of-service have historically included an allowance for taxes paid by their investors. Following a court challenge by United Airlines, FERC has now disallowed this practice.

Since last year’s tax reform, MLPs have already included lower imputed tax expense in their guidance. After the FERC ruling, most firms reaffirmed prior guidance, since the immediate impact of the change is quite narrow. However, the loss of the tax allowance will impact gradually over the next few years. Along with the drop in the corporate tax rate from 35% to 21%, it further reduces the relative advantage of MLPs compared with corporate ownership of energy infrastructure assets.

The trend favoring corporate ownership is well established. As we’ve written before, MLP investors (generally, older wealthy Americans) want their distributions and don’t much care for the distribution cuts that have been necessary to finance growth projects (see Will MLP Distribution Cuts Pay Off?). These investors are income-seeking, not total return oriented. It’s why MLP yields remain stubbornly high, and is behind the many “simplification” transactions that move assets to corporate ownership and cut payouts.

FERC’s ruling probably helps that ongoing trend towards corporations (see FERC Ruling Pushes Pipelines Out of MLPs). MLPs are complex, with a limited investor base, and are losing some of their comparative advantage over corporations because of changes to the tax code. They already represent less than half of energy infrastructure. The tax ruling by FERC doesn’t affect corporate owners, since their tax expense is real, not imputed as was the case with MLPs.

If you’re a direct holder of MLPs, as long as the assets continue to perform there’s not much reason to do anything. You may ultimately wind up owning shares in a corporation if the MLP converts, and it might even be acquired. The tax consequence of waiting is likely no worse than selling your MLP today.

However, investors in many MLP-dedicated funds that are not RIC-compliant face a real dilemma. As the number of MLPs contracts, these funds will struggle to find enough names to own. The Alerian Index has been shrinking for some time, both in market cap and constituents. Investors in the wrong kind of fund face a corporate tax haircut as well as a declining opportunity set.

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There’s some recent evidence since the FERC ruling that investors are starting to favor corporate infrastructure names over MLPs. So far in March, the American Energy Independence Index, which consists of broad energy infrastructure exposure with only 20% in MLPs, has handily outperformed the more narrow, MLP-dedicated Alerian Index by 2.7%. This outperformance has come since the FERC ruling. Anecdotally, we know some investors are switching from tax-paying funds into pass-through, RIC-compliant ones because that’s all we offer and we are seeing the inflows.

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Since last Summer, we calculate that tax-impaired funds have seen net outflows, as investors have become more aware of the performance drag (see AMLP’s Tax Bondage) and the shrinking opportunity set. Meanwhile, properly structured RIC-compliant funds with no tax drag picked up almost $900MM over this time. It’s reflected in the shrinking float-adjusted market capitalization of the constituents of the Alerian Index, which is less than half of its 2014 peak, significantly lower than performance alone would imply.

The number of Alerian constituents has also shrunk noticeably  since 2014. Just six names make up half its market cap, and seven have a market cap of below $1BN. Williams Companies (WMB) could well conclude that the FERC ruling means they’re better off owning their sprawling interstate natural gas pipeline network, Transco, at the corporate level, thereby eliminating MLP Williams Partners (WPZ). Enbridge (ENB) could easily absorb the remaining public float of Spectra Energy Partners (SEP) and Enbridge Energy Partners (EEP) to offset FERC’s impact on their cost-of-service tariffs. Plains GP Holdings (PAGP) will eventually covet the tax shield that would come from absorbing the remaining units of its MLP, Plains All American (PAA).

Combined, losing these four would reduce the market cap of the Alerian index by $24BN, about 17%. By comparison, the two new names added in 1Q18 (Hi-Crush Partners and CVR Refining) have a combined market cap of only $1.5BN. The Alerian MLP Index  is not what it used to be.

The American Energy Independence Index has a float-adjusted market cap of $315BN, more than twice Alerian, reflecting its broader approach. Investors are starting to take note.

We are invested in ENB, PAGP and WMB

Facebook’s (FB) business model should be well understood as extracting value from the enormous amount of data users provide about themselves. Relationships and “Likes” disclose much about an individual’s affinities. Moreover, when a FB user clicks on an ad or even just hovers her cursor over it, FB knows. This knowledge is exceptionally valuable to advertisers, since a great deal of advertising has historically relied on reaching a group you think could be interested without knowing who reacted. The oft-quoted saying that companies know half their advertising budget is wasted, just not which half, shows there’s plenty of room for improvement.

It’s a powerful proposition, and relies on users sharing all kinds of personal details in exchange for freely sharing holiday photos, or which restaurant they’re currently at “enjoying adult beverages.” But as the latest furor over Cambridge Analytica shows, FB doesn’t protect all this data as well as they might, or at least not as well as regulators might like. In some ways it betrays an arrogant culture – since users provide the data about themselves for free, they must not value it very highly. Nonetheless, FB is now Villain #1. Congressional hearings will surely follow, and perhaps even some constraints on the commercialization of free user data into a lucrative advertising platform.

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We had our own experience of FB’s culture as a small advertiser. Last year we launched the American Energy Independence Index, along with an ETF that seeks to track its performance. We were intrigued at what we heard about FB’s precise marketing, which appeared to provide us with the opportunity for targeted ads at FB users whose profile suggested they’d be interested. You’d only pay for users who clicked on the ad. Furthermore, FB’s software would refine our targeted audience based on analyzing the results. So we tried it out.

Advertising of securities including ETFs is highly regulated. Such ads on FB are rare, so we knew we were on relatively new territory. But there is clear evidence that investing is moving farther online, with robo-advisers now offering algorithm-based advice to the next generation of investors. Any ad had to be fully compliant with all the applicable regulations, and unfortunately FB doesn’t allow you to design a mock-up of your ad for internal review. So the FB page was briefly posted and taken down a couple of times as we ensured it was compliant. Product endorsements are also forbidden, so out of an abundance of caution we sought no FB “friends”, to avoid any unwanted “Likes”.

The result was, we looked nothing like a typical FB user. No friends, no interaction with other users, and a page that had been posted for a couple of seconds at a time.

FB is on the lookout for Russians. Or more accurately, internet trolls and other “bots” with nefarious objectives such as influencing our election. Naturally, FB has designed software to screen for suspicious activity, and we met the algorithm’s criteria. Our account was suspended. But the ad, which was compliant with the regulations even if FB was suspicious of the user, continued.

Our corporate credit card was duly billed for activity even while our account was suspended.

And here’s the point. You cannot contact Facebook. There is no number for a customer to call if there’s a problem. Nowhere at all. There’s nobody to e-mail. You can submit an enquiry on a website, and you’ll receive an automated response. We do investment research, which is largely online, so we are not exactly neophytes at finding information on the web. And it became abundantly clear that FB’s advertising business model is designed to avoid the expense of human interaction. I even reached out to someone who works in their Advertising department. We’d played golf last Summer and he’d left me impressed with how their deep knowledge of users could benefit their advertising customers.  Surely, a golf acquaintance could help. He responded with a URL that led to another automated response.

This is why FB is an arrogant company. They don’t believe it’s necessary to provide humans to talk to their customers. This is the same culture that lost control of data provided to Cambridge Analytica. They really don’t care. Perhaps that’s why Procter and Gamble concluded that much digital advertising was a waste.

Finally, we cancelled our corporate credit card claiming unauthorized use. The ads stopped. FB never asked why.

The Shale Revolution, which is leading us to American Energy Independence, is increasingly a technology-reliant business with engineers seated in front of computer terminals remotely guiding a drill bit to within inches of its target. Happily, the energy business still finds value in humans to run things.

We are not invested, and have never been invested, in FB

The fragile mental state of MLP investors left them ill-prepared for Thursday’s ruling by the Federal Energy Regulatory Commission (FERC). By modifying how MLPs calculate certain tariffs, it sent the sector on another wild afternoon ride. It’s a complex issue – pipelines owned by MLPs that cross state lines and rely on FERC-regulated tariffs are most vulnerable. MLPs can no longer set tariffs by including taxes paid by their investors in calculating full cost of service (since MLPs are largely non-taxpayers themselves).

However, it’s possible to find many exceptions – large swathes of the U.S. pipeline network operate intrastate and are therefore generally not governed by FERC. Many contracts are negotiated or have market-based rates, and there are plenty of cases where customers have few attractive alternatives to their existing infrastructure provider. Pipelines owned by corporations rather than MLPs should be relatively unaffected, while non-pipeline energy infrastructure assets are also immune, including gathering, processing, terminals, fractionation, storage, and Liquified Natural Gas facilities.

But the ruling did provide another example of the complexity in the MLP structure. Investors have already had to contend with management teams redirecting cash flows from payouts to new projects (see Will MLP Distribution Cuts Pay Off?). MLP Limited Partners still tolerate their junior position relative to a General Partner (GP) that retains control, although the GP’s payments received via Incentive Distribution Rights (IDRs) are increasingly being phased out. K-1s have always been unpopular, and compounding 2017’s disappointing performance, users of the PWC website for electronic download are confronting additional authentication requirements that add to the burden of tax preparation.

Meanwhile, the FERC ruling exposed one more element of complexity. Calculating cost of service by including investors’ tax expense is another quirky feature of the MLP structure. Such tax rates are in any case unknowable by the MLP. The market’s superficial understanding of the issue was reflected in the sector’s initial 10% drop on Thursday before recovering approximately half, and by Friday prices were barely changed from prior to the ruling. In any event, few contracts nowadays are negotiated in such a way that FERC’s ruling affects them, compared with older, legacy contracts. Figuring in owners’ taxes turns out to be another anachronistic feature of MLPs.

Investors continue to show their disdain for the sector. Management teams long ago broke the implicit contract of stable payouts. The 30% cut in distributions since 2014 is reflected in the 40% drop in the Alerian Index. CEOs promise that much of this redirected cash will result in faster growth, and 15% annual Free Cash Flow (FCF) growth looks plausible to us. But the business model of attractive yields with little need to reinvest in the business has shifted in response to the opportunities created by the Shale Revolution. The older, wealthy Americans who were long the main MLP investor wanted their distributions, and this pursuit of growth projects has alienated them by disrupting their income. Consequently, the market is waiting to see if new projects will generate promised higher returns.

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MLPs now represent less than half of U.S. Energy infrastructure, because the MLP has turned out to be a poor source of growth capital. MLPs are far from irrelevant, but they are a shrinking subset. The FERC ruling was another reason to make both investors and MLPs themselves question whether the structure is still worth the trouble. Furthermore, to be an investor in a dedicated MLP fund is to miss most of the sector as well as incur a substantial corporate tax drag (see AMLP’s Tax Bondage).  Broad exposure to energy infrastructure through a RIC compliant fund that caps MLP investments at less than 25% looks increasingly preferable.

However, there’s another class of investor that sees much to like in energy infrastructure, and that’s private equity. Although there’s limited public data available on transaction prices, these long term investors are steadily investing in long term energy assets. Blackstone acquired MLP asset manager Harvest Fund Advisors last August, in a clear bet on a resurgent asset class, having just paid $1.5BN for 32% of Energy Transfer’s Rover pipeline. Tortoise, another large MLP asset manager, sold out to a group of private-equity firms led by Lovell Minnick Partners. Other private buyers include 4 AM Midstream (acquired midstream assets from White Star Petroleum), Meritage Midstream (acquired Powder River basin subsidiary of Devon Energy), and Stakeholder Midstream (Permian gathering system).

Earnings calls often include grumbling that private equity, with its locked up capital, is outcompeting public MLPs for projects. Energy Transfer’s Kelcy Warren complained, “We lose out on projects routinely these days to private equity, not really to our peer group… there’s just a lot of private equity that hires management teams and they’re in for the short term. But it doesn’t matter, they’re winning and we’re not.”

FERC’s Thursday ruling on tariff calculations added another source of volatility to a sector not short of it. Later in the day, Enterprise Products Partners (EPD) CEO Jim Teague stated, “We do not expect the revisions to the FERC’s policy on the recovery of income taxes to materially impact our earnings and cash flow,” Other large firms soon followed, including Kinder Morgan. So the market’s initial response was disproportionate, but its vulnerability to a relatively obscure issue simply highlighted unnecessary complexity.

Energy infrastructure assets are doing fine, but the MLP entities that own them are taking a succession of body blows. The corporate ownership of energy infrastructure assets, with its access to worldwide equity investors and simpler tax reporting, is looking ever more attractive. On the week, the narrowly MLP-focused Alerian MLP Index was -2.9% whereas the broader American Energy Independence Index was -1.0%, as investors favored corporate ownership over MLPs following FERC’s ruling.

Investors in MLP ETFs such as AMLP, and similar MLP-dedicated mutual funds, already face a corporate tax drag (see again AMLP’s Tax Bondage). They are likely to see MLPs continue to lose favor as a financing vehicle, with a consequent diminution of names to hold. Investors who desire to profit from the Shale Revolution and the path to American Energy Independence should switch out of MLP-focused, tax-impaired MLP funds and into broader energy infrastructure exposure relying on simple corporate ownership of assets with no tax drag.

We are invested in Energy Transfer Equity (ETE), EPD and KMI

FERC’s ruling earlier today disallowing income tax recovery on interstate pipeline contracts is roiling the sector and we continue to analyze the likely impact. We believe it should only affect pipelines owned by MLPs not corporations. In our funds we maintain MLP exposure at below 25%. This ruling may disadvantage MLPs versus corporate owners, and MLP-only funds are clearly most exposed.  This has been an issue for many years and we expect the MLP industry to appeal.

Within the MLPs we own, there are many reasons to expect a limited impact. This does not affect gathering, processing, storage, export, LNG, fractionation or intrastate assets.  Furthermore, many interstate contracts are negotiated based on market based rates instead of subject to FERC rates and others have pre-agreed upon terms for adjustments. For example, Energy Transfer Partners’ (ETP) assets include intrastate (as distinct from not interstate) pipelines in Texas, which are not affected by FERC’s decision today. In other cases, such as ETP’s Dakota Access, there seem to be few good alternatives for shippers as there is still insufficient takeaway capacity from the region with some use of crude by rail. Williams Companies (WMB) Transco pipeline network still looks to us like the cheapest way to move natural gas out of the Marcellus. Although MLP Williams Partners (WPZ) owns Transco, they could theoretically combine with parent WMB and house the assets in a corporation.

It’s possible this could be another justification to shift energy infrastructure ownership from MLPs to corporations, which is where we are mostly invested. We are not currently making any portfolio changes.

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

Last week we spent a couple of days with Catalyst Funds at their annual sales conference in Clearwater, FL. The second winter storm in a week conveniently hit the northeast after everyone had flown south, so travel plans were not disrupted. Catalyst CEO Jerry Szilagyi has been a great partner for our MLP mutual fund, and we were asked to host eight roundtable discussions with the wholesalers who market it. We have developed many great relationships with them over the years, and it was very helpful both to update them on the sector as well as to hear their feedback. Through the Catalyst network, thousands of financial advisors and other investors have become clients. As many people know, I invariably enjoy our interactions with the people whose money we invest.

Many of our financial advisor clients will be meeting with Catalyst wholesalers in the weeks ahead, and we thought it would be useful to summarize our discussions, since they’re hopefully of broader interest. Energy infrastructure investors are frustrated that record production of U.S. crude oil, natural gas and natural gas liquids is failing to boost the sector. Bad news is bad and good news doesn’t seem to help. Sector performance was the most important conversation topic.

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We think the explanation lies in the split of cashflows between investor returns and new projects. This is an issue for the energy sector overall, and not just energy infrastructure companies. Complaints have been loud that too much cash is plowed back into the business, with not enough earmarked for a return on capital to investors. For the past couple of years, net share repurchases by the S&P Energy Sector have hovered at less than 1% of market capital, the worst of any of the 11 S&P 500 sectors. When combined with dividends, at 3.45% the Energy sector yield (Dividends + Buybacks) is the lowest it’s been in a decade and a little more than half of what it was three years ago.

The redirection of cashflow towards growth projects is therefore not unique to energy infrastructure. As we noted last week (see Will MLP Distribution Cuts Pay Off?), dividends on investment products linked to the Alerian MLP Index are down 30% since 2014, while the index itself is 38% off its peak. Energy managements need to show that the cash they’ve redirected has been invested wisely. For now, any new growth initiative generally receives a big thumbs down from investors.

A consequence of the need for growth capital has been the decreasing relevance of the MLP model for energy infrastructure. The two are no longer synonymous, with MLPs representing less than half of the sector. Investors seeking exposure to the infrastructure supporting American Energy Independence need to look beyond MLPs.

MLPs are valued as if the 30% in distribution cuts is gone forever, whereas in many cases CEOs have justified it as financing attractive projects. A commensurate increase in Free Cash Flow (FCF) over the next couple of years would provide some vindication of those decisions. The market is waiting to see evidence. We have calculated that 15% annual FCF growth across a broad swathe of energy infrastructure corporations and MLPs (as represented by the American Energy Independence Index) is likely. As evidence of that starts to show up, it should be the catalyst the sector needs to rebound.

The other important topic concerned opportunities to upgrade portfolios for investors who are already in energy infrastructure but unfortunately chose one of the tax-impaired funds. We wrote about this recently, in AMLP’s Tax Bondage. Although the title reflects our own shot at search engine optimization, the blog post highlights the tax drag that has led to AMLP performing at less than half its index. This might be the worst ever result for a passive ETF. It’s a regular subject for us, and recently Forbes published a splendid analysis of the burden faced by unwitting investors in such funds (see A Tax Guide to MLP Funds). Writer Bill Baldwin did some serious work to validate what we’ve been saying, and has performed a great service to investors in tax-burdened MLP funds everywhere.

The point of the tax discussion is to remind investors in the wrong type of energy infrastructure fund that this is a great time to sell (probably realizing a tax loss that might be a  useful offset against a FANG stock), so as to switch into a tax-efficient fund (which is the only kind we run).

In summary, pervasive energy infrastructure weakness awaits evidence that FCF growth is coming, and the timing is great for a portfolio upgrade by shedding tax-inefficient funds. This is the two-pronged message to investors and prospects in the sector. As conference attendees prepared to return to homes and spouses that are mostly located somewhere colder than Florida, the limited opportunity to get tanned was probably for the best.

It’s surprisingly difficult to find out what MLP distributions have been doing. Alerian claims that their index has been growing its payouts at a 6% average annual rate for 10 years, with growth continuing in 2016 (it’s not yet updated for 2017). However, their methodology is odd. They take the trailing growth rate of the current index constituents, which are regularly updated. This tends to bias the growth rate up, because they dump poor performers and add good ones. We examined this in a recent blog (see MLP Distributions Through the Looking Glass).

Because Alerian doesn’t publish the actual experience of its index investors, it’s necessary to look at how investment products tied to those indices have done. Not surprisingly, payouts have fallen. As the chart shows, for the JPMorgan MLP ETN (AMJ) and for the Alerian MLP Fund (AMLP), two of the largest vehicles in the sector, dividends are down approximately 30% from their highs in 2014-15. This is what MLP distributions have been actually doing – falling, not rising — in spite of what is sometimes implied. Perhaps coincidentally, the cut in payouts is similar to the drop in the sector (38%) from its August 2014 highs.

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As we’ve written before, the Shale Revolution induced many MLP managers to pursue growth opportunities (see More on the Changing MLP Investor). The need for growth capital pressured financial models that historically distributed 90% of Distributable Cash Flow (DCF), when growth needs were minimal. Leverage rose, growth projects were favored over reliable payouts, and distributions were cut. Investors felt let down if not deceived.

Although the big picture is simple, at each company level there are more detailed reasons why growth plans that were not expected to threaten payouts nonetheless led to cuts. Plains All American (PAGP) saw its Supply and Logistics business drop from $900MM in EBITDA to less than $100MM over two years. Kinder Morgan (KMI) was hurt by the cyclicality of its Enhanced Oil Recovery business. But broadly speaking, the dividend cuts were a redirection of cashflows into new projects, rather than reflective of poor operating results.

Over the next couple of years we’ll see if that redirection of cash pays off. The Miller-Modigliani model of corporate finance holds that investors should be indifferent to a company’s capital structure, and should not value dividends (since anybody can create a 5% dividend by selling 5% of her shares annually). Although financial markets don’t always operate that way, the question hanging over the industry is whether these redirected cashflows will eventually deliver their pay-off. If the foregone dividends have been wisely invested, DCF should grow.

We’ve looked at this for the components of the American Energy Independence Index. It consists of 80% corporations and only 20% MLPs. Since many MLPs have converted to C-corp status, energy infrastructure is leaving MLPs with a diminished status. It includes some Canadian companies, since they also operate U.S.-based infrastructure assets and, as we’ve noted, have been rather better run of late than their American peers (see Send in the Canadians!).

Using company data and estimates from JPMorgan, we calculate a two year compound annual growth rate of DCF for this group of businesses of 15%, from 2017 to 2019. Some of these companies were in the Alerian index but left as they became C-corps, some were never in, and some still are. A perfect match is impossible because the constituents of the Alerian MLP index have changed over the years. But that 15% growth rate will significantly support the correctness of those decisions to redirect cashflows from payouts to new opportunities. It won’t be true in every case, and to be sure many investors would have preferred it didn’t happen. But it will provide a form of vindication for managements that increased investment back into their businesses.

The sector has been priced as if the distribution cuts were fully reflective of weaker operating results, whereas in most cases they’ve been to support future growth. Investors appear to be assuming away the foregone distributions, as if the operating cashflows supporting them have disappeared, whereas many companies have been financing growth plans with this internally generated cash.  MLP investors are likely not passionate about Miller-Modigliani, but we’ll see in the months ahead whether the theory has worked.

We are invested in KMI and PAGP