Last Monday, June 22nd, Energy Transfer Equity (ETE) went public with their rejected merger proposal to Williams Companies (WMB) in an effort to force WMB to the negotiating table. WMB’s stock rose by most of the 32% premium ETE has offered, and in recent days has held on to most of that gain as the market has assessed likely outcomes. ETE’s presentation highlights the synergies of such a combination. Another comforting fact is the ownership of WMB stock by hedge funds Corvex and Soroban, who hold 5.6% and 2.8% respectively. Corvex has not always been a positive influence for stockholders, and last year we wrote about the “Corvex Discount” that should apply to any stock they own (see Williams Companies Has a Corvex Discount). However, in spite of this we are long-time investors in WMB. It’s worth noting that Corvex and Soroban are on WMB’s board, so their views will be a factor in any decision.

The headlines will focus on developments at WMB as they consider their strategic options in light of ETE’s interest in them. We think WMB is likely to move higher as a result. What’s drawn less attention is the likely outcome for Williams Partners (WPZ), the MLP that WMB controls as its GP. On May 13th, WMB announced plans to acquire the outstanding units of WPZ, in a transaction intended to boost WMB’s dividend growth in part through tax gains from depreciating the newly acquired assets from a higher valuation. It’s the same technique used by Kinder Morgan last year to fuel faster distribution growth at KMI when they announced plans to combine Kinder Morgan Partners, El Paso and Kinder Morgan Management into one entity (see The Tax Story Behind Kinder Morgan’s Big Transaction). The tax insight KMI had was that acquiring assets from a limited partnership allows them to be revalued at the purchase price, and thereafter depreciated against taxes from this higher level. The practical consequences were $20 billion in tax savings for KMI which helped fuel a doubling of their forecast dividend growth to 10%, and an unexpected tax bill for Kinder Morgan Partners unitholders since the transaction resulted in a sale of their LP units not necessarily at a time of their choosing.

WMB’s previously announced plan to acquire outstanding WPZ units is also driven in part by this favorable tax treatment. However, ETE’s merger proposal is conditional on WMB dropping its announced plans to buy WPZ. ETE doesn’t want that transaction to go through. As a result, although WMB’s stock rose substantially following the announcement, the price of WPZ units fell.

To understand why, you have to regard MLPs as hedge funds and MLP GPs as hedge fund managers, a view we’ve long articulated and one evidently shared with the senior managers of many MLPs (see Follow the MLP Money). If you want to control the assets of a hedge fund, you do that by controlling the hedge fund manager, not by investing in the hedge fund. Similarly, Kelcy Warren (ETE’s CEO) understands that to control the assets owned by WPZ he need only control WMB’s GP, not WPZ itself. Under this analysis, paying a premium to acquire WPZ units may not be the best use of capital, and in fact leaving WPZ as a publicly traded MLP (albeit with two thirds of its LP units owned by WMB) provides optionality. If WPZ’s cost of capital falls, ETE may drop assets into it where they can be cheaply financed. Or, if WPZ’s yield remains high they may retire some LP units. Having WPZ remain out there is, in ETE’s view, a good thing. It shows that the decisions get made by the owners of the MLP GPs, not the MLP unitholders themselves. As we’ve said before, the MLP GP is like a hedge fund manager.

A question I’m often asked is how the business prospects of many MLPs will respond permanently to lower prices for oil and gas, perhaps lower than where they are today.

From a high level, markets often appear vulnerable to a correction. This is especially true with the S&P500. You rarely hear anyone simply say the market looks cheap, and in fact it’s easy to find reasons to worry. Today it’s rising rates and the threat of Grexit, but there’s always something to worry about. And if there isn’t, then you can worry about complacency. For me, the solution is to look at individual companies, because while the market outlook can be uncertain, the prospects for (fill in the blank) corporation often appear far more tangible and clear than for the broader averages.

The same is true with MLPs. Prices have fallen along with the energy sector. So look at Cheniere Energy and their LNG export facilities at Sabine Pass, LA and Corpus Christie, TX. It may seem quaint to remember, but not that many years ago the U.S. was preparing to import LNG. The two abovementioned facilities were built for that reason, until the boom in domestic natural gas production led to a glut and rendered the economic assumptions underlying imports no longer valid.

So the facilities were switched to export LNG instead. This is not a trivial task. Natural gas has to be compressed and cooled to around -256 degrees Fahrenheit before being piped into the large spherical tanks you see on LNG tankers. Handling LNG is far harder than crude oil, and the regulatory oversight is substantial as you might imagine. An accident at an LNG terminal would be a spectacular sight as long as viewed from many miles away.

Cheniere’s CEO Charif Souki has a substantially bigger risk appetite than ours, as I’ve written before (see U.S. Natural Gas Terms of Trade Continue to Shift) but he is close to starting operations at the first LNG export facility in the lower 48 states. The relevance to MLPs of this milestone is that the natural gas that Cheniere will export has to be transported to their terminals via pipeline and stored prior to processing and loading onto LNG tankers. Two important infrastructure providers are Kinder Morgan (KMI) and Williams Companies (WMB). KMI announced plans to provide pipeline capacity and storage for Cheniere’s Corpus Christie facility back in December.

WMB will be expanding its Transco pipeline network, an enormous connection of pipelines and supporting infrastructure running down the eastern U.S. from the north east to Texas. Last year they announced they’d be building Gulf Trace which will bring natural gas from the Marcellus Shale in Pennsylvania down to the Sabine Pass LNG export terminal and from there to foreign customers.

The question of whether low commodity prices are good for energy infrastructure is not one that can be answered with a simple “yes” or “no”. The LNG export projects provide an example of how the domestic energy business is exploiting opportunities from low domestic prices.

We are invested in KMI and WMB.

People often ask me how I think equity markets, including Master Limited Partnerships (MLPs), will perform when interest rates are rising. It’s a timely question, since bond yields have been moving higher for the past couple of months. The yield on the ten year U.S. treasury recently touched 2.5% as markets look ahead to a tightening by the Fed later this year. Of course, the Fed has been steadily pushing back the first rate hike, since it turns out they’re not any better at forecasting rates than the private sector, as I wrote a couple of months ago in Preparing for Higher Rates. Nonetheless, they will be right eventually and financial advisors would like to be prepared.

The relationship between interest rates and most asset classes is not simple. Bond prices mathematically fall with rising yields since their payouts are fixed, but equity securities whose return comes from both dividends and dividend growth have a more complicated relationship with rates.

Stronger economic activity can be expected to translate into faster profit growth and higher dividends, in which case higher rates represent confirmation of a more robust economy and need not be negative. Conversely, if rates rise while inflation is unchanged, it results in higher real rates (i.e. after inflation) and this in theory reduces the value of all assets.

But we know rates will rise, and the yield curve is pricing in the expectation of a higher Fed Funds rate in the next 6-12 months. So part of the question comes down to what the market will do if the market’s own forecast of the timing of rising rates turns out to be correct. In this respect, it boils down to a question of market psychology; if rates rise following the path already reflected in the yield curve, it ought not to surprise. In fact, the prices of treasury bonds ought not to change, in theory, since their prices already reflect that path. They obviously will move, but where will they, and equity markets, settle?

I have a friend who has an exceptionally acute sense of such things. Through seemingly logical analysis, he often arrives at an insight that sometimes seems so obvious but wasn’t at all clear until he pointed it out. On this topic, he recently noted to me that if he was considering buying stocks but planned to sell upon a Fed rate hike later this year, he wouldn’t invest. It seems so blindingly obvious, but if something unsurprising will happen that would cause you to sell, you would avoid putting yourself in that position.

Therefore, if you put yourself in the mind of this mythical yet rational investor; if this participant isn’t going to sell stocks at that time, who is? And the answer is, people with a short term horizon who expect selling by others and wish to avoid a near-term drop in their portfolios, or hope to buy back shortly afterwards. And from whom exactly will they buy back their shares, if our mythical yet rational investor (perhaps with many like-minded folk) is not then a seller?

This is exactly the kind of set-up that can cause equity markets to reach higher prices than existed prior to the “news”, as the participants expecting to buy from other more hasty investors find far fewer such impulsive folk exist than they might have expected. We don’t forecast equity markets, but don’t be shocked if stocks rally on the first rate hike.

The analysis of market psychology is of course an endless game that never ends. Events big and small are anticipated, happen and are reacted to along with big and small surprises too. As soon as the aftermath of one event reveals the true disposition of willing buyers and sellers through their subsequent actions, the build-up to another event begins. It’s very hard to be good at figuring this out, and in my experience the supply of people with opinions far and away exceeds the number whose views result in profitable outcomes. But I know just a very few who have turned astute observation into market profitability.

For our part, while this type of prognostication can be fascinating, there isn’t a plausible move in interest rates that would cause us to sell investments which are, by definition, held for the long run. Several months at least lie between today and the resolution of that particular event. When it happens, if equity markets fall, we shall be among those whose portfolios suffer a loss in value. However, we shall not be a seller in response to something not surprising. Ben Graham is believed to have said that in the short run the market is a voting machine while in the long run it’s a weighing machine. We’ll weigh things up down the road.

Plains All American Pipeline (PAA) held their Investor Day on Thursday. The presentations included a fascinating analysis of the global oil market with a view to forecasting prices as well as regional supply/demand, since these are important drivers of PAA’s planned infrastructure development. The chart at the left, reproduced from PAA’s Investor Day deck, plainly shows the impact of growing North American output on the global market. Since 2011 global supply has increased by a little over 4 MMB/D, 1.4MMB/D in excess of demand growth which is why inventories have grown. Moreover, North America has met more than 100% of this increase in global demand, since output in the rest of the world has net fallen somewhat. This simple graphic illustrates as well as anything that the Shale Revolution in the U.S. has not just been a North American story but has impacted the global oil market, most obviously through the drop in prices since last Summer.

A corollary to this is that growing U.S. production is reducing import demand, as U.S. refiners process more domestic crude oil. However, U.S. refineries are generally better able to process the heavy crude that we’ve historically imported, and the light sweet crude that is typically produced from domestic fields is not as good a fit for many refining facilities. There are also distribution bottlenecks which are gradually being alleviated, but in combination these two factors along with the ban on crude oil exports account for the discount of WTI crude compared with Brent.

The export ban dates back to the 1970s, and looks increasingly anachronistic today. You might expect the oil industry (excluding refiners who benefit from captive suppliers) to favor repealing the export ban. Greg Armstrong, PAA’s CEO, acknowledged the free market argument in favor of doing so but also conceded limited political support for such a move. It would seem intuitive that allowing domestic oil to be sold overseas would raise its price and therefore increase the cost of domestic refined products, including gasoline, which explains the limited political support.

Surprisingly though, quite a number of independent studies have concluded that allowing U.S. exports of crude oil would lower domestic gasoline prices. The analysis predicts that selling U.S. oil on the world market would increase global supply and further stimulate domestic production, thereby lowering gas prices. It’s not obvious; unsurprisingly,  the American Petroleum Institute makes the case but among the many sources they cite are included the Federal Reserve Bank of Dallas and the Congressional Budget Office, two entities not that connected to E&P. So although political support isn’t strong today, the economic case is more supportive than you might first think. Lifting the ban would be good for the domestic energy industry including infrastructure.

On a different topic, Greece is once again in the news as another critical deadline approaches. It may not be much appreciated or even known by their creditors, who are now largely the IMF and the ECB, but as I wrote in Bonds Are Not Forever, since gaining independence from Turkey in 1822 Greece has been in default approximately 50% of the time. Given this checkered history as a reliable debtor, the repayment expectations of Greece’s creditors are barely credible. Under the capital guidelines on developed country debt in force prior to the 2008 financial crisis, Greece’s debt drew the same capital requirements as Germany’s for those banks which held it (which were numerous), in willful defiance of history as well as common sense. Much of that debt is now held by their current creditors, having been transferred from private hands to public in a prior renegotiation. But it seems to me that if it’s stupid to borrow what you can’t repay, it’s stupider to lend what probably can’t be repaid. Greece is an example of the general abundance of debt in the financial system. While not every borrower is Greece, today’s bond investors are offered an unlimited supply to choose from, yet at yields that would suggest scarcity. The thoughtful bond investor is switching asset classes.

We are invested in Plains GP Holdings, the General Partner of PAA.

Inspiration for these posts often comes from conversations I’ve had with investors during the prior week. For a great many investors, the decision to invest in an MLP mutual fund or ETF goes something like this:

1) MLPs have generated attractive historical returns over (choose your time period) number of years

2) The yield on the Alerian Index is around 6%, which looks good.

3) But MLPs generate K-1s, which I don’t understand and my accountant hates

4) However, there are mutual funds and ETFs which invest in MLPs but give you a conventional 1099

5) I should invest in one of them

What this analysis misses is the heavy tax burden these funds endure, which sharply reduces the returns to investors. The conversion of K-1s received by the fund into 1099s received by the ultimate investor comes at the price of a 35% corporate income tax on those returns. So you’re going to receive 65% of what the fund actually receives on its investments.

There are many examples; let’s look at the Mainstay Cushing MLP Premier Fund (CSHAX), whose Fact Sheet reveals an expense ratio of 6.97% to 7.72% (depending on the share Class). They call it a “Gross” ratio (which is an apt name because it is pretty gross) to highlight that most of the expenses do NOT go to the manager. They go to the U.S. Treasury instead. These expenses are still borne by the investor though. CSHAX has returned between 5.7% and 7.1% (depending on share class) since inception in October 2010, compared with 9.4% for the Alerian Index. In fact, it correctly doesn’t compare its performance with the benchmark nor seek to achieve an equivalent return. It can’t.

Goldman’s MLP Energy Infrastructure Fund (GMLPX) has an expense ratio of 3.16% to 3.56%. Most of the MLP funds out there pay substantial taxes. Although MLP returns have been good — for example, the Alerian Index has returned 14.28% per annum over the five year period through April 2015 — the investors drawn to the sector by this history and the attractive prospects are unlikely to earn close to the returns of the index by investing through funds like these because of the tax drag.

Now that a few years of performance have revealed how poorly these funds do against the benchmark, the reality of the huge tax drag is becoming apparent to many investors.

It’s worth looking carefully at the MLP funds you own to see if you’re contributing substantial chunks of return to the U.S. Treasury. Not all funds are structured in this way. And those that are not subject to corporate income tax only need to earn 65% of the pre-tax return of the funds that are subject to the tax to do just as well for their investors. It shouldn’t be hard to do substantially better.

Data recently released by the Energy Information Agency (EIA)  highlighted the continuing shift in U.S. terms of trade regarding natural gas. The North East U.S. (NY, OH, PA, NJ, MD, DE and VA) was for the first time in 2014 no longer a net importer of natural gas from Canada, as production in the Marcellus Shale in Pennsylvania finally grew so as to make the region self-sufficient. The Great Lakes states (MI, WI, MN) have been net exporters for several years, now joined by another region as defined in the EIA’s release.

Even though the North East is reducing its reliance on Canadian natural gas, there remain infrastructure bottlenecks in New England preventing sufficient peak supplies reaching customers. Boston paid as much as $30/MCF for natural gas this past winter to meet high electricity demand, and limited regional pipeline capacity is expected to cause continued seasonal spikes for the next few years. The states in the region have begun to co-ordinate their efforts to improve access to electricity, natural gas and renewables. Spectra Energy (SE) is just one of the energy infrastructure companies seeking support from state and local governments in the region for its plans to improve natural gas distribution.

In related news, the first LNG export facility in the lower 48 states is expected to begin operations later this year (The Kenai LNG export terminal in Alaska is currently the only source of U.S. LNG exports). The Sabine Pass facility in Louisiana is owned by Cheniere Energy Partners (CQH). It is run by a colorful character named Charif Souki, memorably portrayed in Greg Zuckerman’s 2014 book The Frackers. Last year CQH’s parent company, Cheniere Inc (LNG) was forced to withdraw its proposed compensation plan following investor lawsuits arguing it was too generous. Meanwhile, CQH spent $17MM on distributions to MLP investors last year, no doubt fostering a warm feeling about their stable business. However, unlike most MLPs, distribution coverage isn’t a useful metric since CQH has no revenues yet. One wonders how many unitholders actually know that. No doubt when  the Sabine Pass facility begins operations their income statement will look wholly different, but this was one name that didn’t make it through our screening process, although LNG exports remain a fascinating story.

As an aside, in a previous career as a restaurant operator Souki had the misfortune to own the L.A. restaurant where Nicole Brown Simpson, OJ Simpson’s wife, last ate prior to being murdered in 1994. Souki’s business career includes episodes of near-bankruptcy and it’s fair to say he and I have different risk appetites. However, having successfully converted Sabine Pass from an LNG import facility to one that exports, he’s likely to be one of the winners from U.S. energy independence.

Of the names mentioned, we are invested in SE.

Last week Williams Companies (WMB) simplified their structure by acquiring the assets of their Master Limited Partnership (MLP), Williams Partners (WPZ). As was the case with Kinder Morgan’s (KMI) move last year, the objective was to move to a simpler structure with a lower cost of equity driven by faster dividend growth supported by a bigger tax depreciation shield. Although the effect wasn’t as big as with KMI, WMB was similarly able to take advantage of depreciation rules that allow assets acquired from a partnership to be written up to current market value, thus creating a higher level from which tax-deductible depreciation can be made. This contrasts with the rules that apply when a corporation is acquired, whereby the excess over book value paid by the acquirer is reflected as an intangible asset (goodwill). No similar depreciation of goodwill is allowed. Given the choice, you’d rather buy assets from a limited partnership than a corporation, since in the depreciation rules are more favorable. WMB expects to realize a $2.1 billion benefit over 15 years from this stepped-up cost basis which will support a dividend growth rate of above 10%. Its 4.9% yield looks attractive.

Regular readers of this blog might have started to feel that we never come across an MLP General Partner that we wouldn’t like to buy. Although we think the sector is attractive, this isn’t true of every security. EQT GP Holdings (EQGP) recently started trading following its IPO. EQM Midstream Partners (EQM) is an MLP focused on natural gas gathering, storage and transmission in the Marcellus shale in SW Pennsylvania and West Virginia. EQGP is its GP, with Incentive Distribution Rights over its cashflows.

We were potentially interested in EQGP depending on pricing. However, its forecast first year distribution of $0.365, even if combined with a heady growth rate of 40%, had us thinking that a mid-$20’s price for the IPO would be a full price but probably justified because of the growth outlook. The IPO buyers regarded us as needlessly conservative however, and EQGP commanded a low $30’s price from inception. Too rich for us; we’ll wait for another pitch.

Of the names mentioned, we are invested in KMI and WMB.

Several Master Limited Partnerships (MLPs) announced their quarterly earnings last week. The overall picture continues to be one of businesses performing well with good distribution coverage and continued plans to grow their infrastructure networks while responding appropriately to shifts in the domestic production landscape.

So Enterprise Products Partners (EPD), an MLP with no Incentive Distribution Rights (IDR) drag detracting from its investors’ returns, announced their 43rd consecutive distribution increase of 5.6% compared with a year earlier. Their payout is also covered at 1.4X by Distributable Cash Flow.

Oneok Inc., (OKE) the General Partner (GP) for Oneok Partners (OKS) was a more nuanced story. The stock price fell following the earnings release as the distribution remained flat on a quarterly basis (+8% on a year ago). Of note was that cashflows to OKE from OKS, reflecting its role as OKS’s GP, were $169MM, +16% on a year ago. Interestingly, Net Income and DCF at OKS itself fell in 1Q15 compared with the prior year. They explained it so, “Variances in financial performance between the first quarter 2015 and first quarter 2014 were primarily a reflection of significantly higher weather-related seasonal demand, resulting in higher prices for propane and natural gas, in the Midwest due to severely cold weather during the first quarter 2014 and the continued impact of commodity price declines in the first-quarter 2015.”

A cold 2014 winter and lower commodity prices this year affected earnings. The GP experienced more stability in its earnings than was reflected in the underlying MLP it controls. Nonetheless, full year guidance was confirmed as unchanged both for OKS and OKE. OKE’s coverage of its distribution was 1.2X which prompted one analyst to ask on the earnings call whether OKE might even use some of its cash to buy OKS units on the open market. You could interpret the absence of a dividend hike by OKE as symptomatic of a tougher business environment, or you might regard their resulting comfortable distribution coverage as reflecting an abundance of caution. We lean towards the latter.

Overall, for these two MLPs, business seems to be going well. We are invested in EPD and OKE.

We noticed several interesting slides from an investor presentation by Enterprise Products Partners (EPD) recently. The first concerns future capital investment plans of Master Limited Partnerships (MLPs). As you can see on the first chart, lower oil prices have caused some moderation in forecast capital expenditures (“capex”) and a drop in 2016 versus 2015. However, the numbers remain substantially higher than the pre-2013 period, and support the forecast of $30-50BN in annual capex for energy infrastructure (since while MLPs are the main operators of such assets, integrated oil companies and utilities also fund energy sector projects).

Part of the MLP story in recent years has been the growth in infrastructure build-out to support the exploitation of shale assets. While the rate of growth is flattening out, projected asset growth at MLPs remains strong. Just as hedge fund managers benefit from asset growth in hedge funds, so should MLP General Partners expect to benefit from running bigger MLPs.

Another interesting slide concerned the growing interest in petrochemical facilities to take advantage of cheap natural gas in the U.S. As the table at right shows, the U.S. is fast developing a healthy trade surplus in petrochemicals exports.

Perhaps the most interesting insight was contained in the third chart, highlighting where oil production has been growing and where it hasn’t. As the chart title asks, “Why Couldn’t OPEC perform?” The rational response to the steady increase in oil prices over the past decade (albeit with a substantial fall and recovery in 2008-9) caused by growing demand from emerging economies should have been to match that increase with higher output, thus arresting the price increase and rendering other, unconventional sources of crude oil production uneconomic while still at a nascent stage. But OPEC, and most notably Saudi Arabia, failed to take this logical step. This created the opening for North American output to develop, meeting the increased demand while lowering its unit cost of production through economies of scale and ongoing technological improvements.

That OPEC didn’t do this suggests that they couldn‘t, and highlights the difference between very low production costs for proved, developed reserves in the Middle East versus relatively high costs to develop new resources beyond what is already in production. Clearly, from the perspective of a group of producers that still satisfies roughly one third of global oil demand, a modest increase in output to maintain market share and render new sources of supply uneconomic early on would have been a far less costly strategy than the current one of maintaining fairly constant output regardless of price. It suggests that even countries such as Saudi Arabia have a fairly limited capacity to increase output over the short term.

North American shale production, with its ability to adjust output quite quickly in resopnse to price changes, is turning out to be the swing producer. If this analysis is correct, it should result in a more stable oil price than we’ve seen in the last year since a more flexible supply response to price movements now exists.