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.

In an interview on CNBC last week, Continental Resources CEO Harold Hamm elegantly exposed the increasingly anachronistic ban on crude oil exports from the U.S. By noting that sanctions on Iran would soon be lifted, allowing that country to once again export oil, he characterized the U.S. export ban as a self-imposed sanction, benefiting other producers and certainly not helping the U.S.

It’s an obvious contrast to draw, and such a devastating soundbite targeted at the dwindling supporters of maintaining current law, which dates back to the 1973 Arab Oil Embargo when the world was a very different place. Some believe that U.S. producers could realize an additional $5-14 barrel by selling to overseas customers. Other 1970’s era energy-related laws such as price controls and rationing were dropped long ago. In fact, arguably the main beneficiaries of current law are domestic refiners who are able to buy crude oil in a domestic market with fewer options than it might otherwise have.

Alaska’s senator Lisa Murkowski has promised to introduce legislation repealing the ban. Ever since oil began its collapse last Summer, hurting employment in a booming domestic energy industry, the ban has received increasing attention. Conventional wisdom continues to hold that the status quo will prevail. This may be so, but sometimes a position can be summed up in a soundbite that works for TV or for a speaker on the Senate floor looking for a 10 second clip on the nightly news. The contrast between lifting sanctions on Iran and maintaining our own self-imposed one is a powerful one easily communicated in a single sentence. It just might shift the debate, since articulating the opposite view doesn’t offer anything like the same optics or brevity of response.

If the oil export ban is eventually lifted, it’ll benefit a number of Master Limited Partnerships (MLPs) that have assets that handle liquids, including Magellan Midstream (MMP), Energy Transfer Equity (ETE), because of its ownership of the GP in Sunoco Logistics (SXL), and Plains GP Holdings (PAGP). Other MLPs, such as Targa Resources (TRGP) and Enterprise Products Partners (EPD) have Gulf Coast based assets that would also benefit from increased movement of crude oil through the Gulf on its way to foreign markets. We are invested in all the names just mentioned.

Schlumberger (SLB) provides services worldwide in support of gas and oil exploration and production companies. They are at the sharp end of shifts in production, and as such have an interesting perspective on the upheaval in the crude oil market. A recent investor presentation highlighted that increased global demand of around 1 MMBD (million barrels per day) annually has been fully met by higher North American output. Global supply capacity away from North America has remained flat. Increased production from North America (from just under 12 MMBD in 2011 to 16 mmbd last year) is of course not news, but I thought the fact that this has fully accounted for increased global demand and not just a portion of it highlighted the importance of unconventional drilling.

OPEC has consequently been losing market share, and OPEC’s desire to push back against this loss in behind price drop. Historically, OPEC spare capacity has tracked the price of Brent crude oil fairly closely, as can be seen in the chart on the left. This was in effect OPEC (mainly Saudi Arabia) acting to smooth oil price swings by countering moves up (down) in price by reducing (increasing) their spare capacity. Over the past couple of years OPEC’s spare capacity has been falling both as MMBD but also as a percentage of demand as they lost market share to new North American production. Their maintenance of relatively low spare capacity in the face of the fall in price (as opposed to past practice whereby they would increase spare capacity, or reduce production somewhat) is of course what we’ve seen.

The real question is what does it mean for prices in the future. North America is now the swing producer. Break even costs vary widely and it’s not meaningful to talk about a shale break-even price. The sharp drop in the rig count in recent months illustrates how responsive new activity is to prices; unconventional drilling results in wells with faster decline rates, so new wells are always being drilled. EIA forecasts are for a flattening of U.S. oil production this year and a modest drop in 2016. Much will depend on the ability of domestic producers to continue to reduce their costs, which is where Schlumberger and its competitors play a key role.

Meanwhile, U.S. oil stocks are approaching 500 million barrels, almost 20% above the top of the five year range, which makes it a good time to be an MLP with storage assets. The worst environment for energy infrastructure is one of demand destruction, usually caused by excessively high prices. That is clearly not today’s world. The mutual fund we manage is doing very well in its Morningstar category.

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The other day someone was asking me for a simple explanation of how MLP General Partners (GPs) enjoy a superior position to those of the LP unitholders in the MLPs they operate. There are many ways to show that, but I thought I’d pull some information from the recent 10K filed by Plains All America (PAA), a well regarded MLP that’s  controlled by its GP, Plains GP Holdings (PAGP).

Highlights from the 10K include:

“Our general partner manages and operates the Partnership. Unlike the holders of common stock in a corporation, unitholders will have
only limited voting rights on matters affecting our business. Unitholders have no right to elect the general partner or the directors of the general
partner on an annual or any other basis.”

In other words, owning units of PAA won’t allow you to influence the business.

“In addition to distributions on its 2% general partner interest, our general partner is entitled to receive incentive distributions if the
amount we distribute with respect to any quarter exceeds levels specified in our partnership agreement. Under the quarterly incentive distribution
provisions, our general partner is entitled, without duplication and except for the agreed upon adjustments discussed below, to 15% of amounts
we distribute in excess of $0.2250 per unit, 25% of the amounts we distribute in excess of $0.2475 per unit and 50% of amounts we distribute in
excess of $0.3375 per unit.”

This illustrates how the GP gets an increasing portion of the cash generated by PAA. Even if PAA grows its business by issuing new debt and equity to fund expansion, the GP is entitled to its share of this bigger business without having to put up additional capital. It’s like a hedge fund or private equity manager. 

And although it turns out that a two thirds vote of the LP unitholders can result in the ouster of the GP, there’s this little gem:

“…generally, if a person acquires 20% or more of any class of units then outstanding other than from our general partner or its
affiliates, the units owned by such person cannot be voted on any matter;”

Owning more than one fifth of the LP units means you lose your vote, so it takes a minimum of four independent owners of a block of securities acting in concert to get around this. 

PAA is a very well run business with highly regarded management, so there’s little reason for investors in PAA to be dissatisfied. But given the preferential economic and governance rights described above, if you can control PAA through ownership of PAGP, why wouldn’t you?

On another topic, last June shares in Targa Resources Corp (TRGP) closed at $150 on hopes Energy Transfer Equity (ETE) was about to buy the company. When the deal fell apart TRGP’s stock fell.  Little more has been heard on the topic, and much has happened in the energy sector since June including a collapse in the price of crude oil. In the meantime, TRGP trades at $100, down by a third or more from its potential value in a deal last June. TRGP recently acquired Atlas Pipeline Partners and Atlas Energy, increasing its asset footprint.

TRGP yields 3.2% and its dividend has been growing at 29% annually, likely making it an accretive acquisition for ETE whose CEO Kelcy Warren is looking for M&A opportunities exposed by the drop in crude oil.

We are invested in PAGP, ETE and TRGP.

Exxon Mobil publishes a long term energy outlook (The Outlook for Energy: A View to 2040) which they update annually. It’s full of interesting facts and charts on energy use and is well worth reading. Integrated energy companies like Exxon Mobil commit capital to projects whose payoff can take decades, and so they are inevitably in the long term forecasting business. The Outlook for Energy provides a perspective on their thinking as well as an interesting snapshot of likely shifts in energy consumption.

Globally, the number of middle-class households (defined as having discretionary income to spend beyond basic necessities) is the most important input into the demand side. Although demographers forecast global population to rise by 2 billion to 9 billion by 2040, more significant for energy demand will be the more than doubling of members of middle class households in just fifteen years, from 1.9 billion to 4.7 billion by 2030 (according to the Brookings Institution). In spite of this, The Outlook for Energy anticipates substantially slower rate of actual energy demand as energy intensity (the amount of energy required to produce a fixed amount of GDP) improves in the developing world to reach present day levels in the U.S.

Half of the increase in energy demand from Transportation will occur in China and India, as a result of which heavy-duty use (trucks) will substantially outpace light-duty (mainly private automobiles). In spite of an expected near doubling in the number of cars of the roads, substantial improvements in energy efficiency will result in little overall change in energy demand from this sector.

As a result of increased efforts to control pollution, CO2 emissions are expected to eventually flatten out and then begin declining over the next 10-15 years. Given the uneven nature of such initiatives globally, this must be one of the more speculative forecasts.

The most significant change in long term supply in recent years is most assuredly the development of “tight”, unconventional oil and natural gas liquids (NGLs) in North America. In just a few years unconventional gas production in North America is likely to exceed the total from the Middle East, turning the U.S. into a significant net exporter within ten years. Although coal will continue to be a substantial source of electricity supply through coal-burning power stations, it has been falling as a percentage of fossil fuels used for many years. In fact, recently Beijing announced it would be closing its last coal-fired power plant by the end of 2016.

Overall, The Outlook for Energy provides a useful global, long term perspective and highlights America’s place evolving role as a producer.

Activist hedge funds can be a positive force. Although this isn’t always true (Keith Meister of Convergex so abused ADT investors that his actions caused us to apply the “Corvex Discount” to other stocks in his viewfinder), it’s probably more often than not beneficial to existing investors when a hedge fund shows up.

The most recent case involves Tetra Technologies (TTI), about which we wrote a few weeks ago as an example of the power of the MLP General Partner. Dimitri Balyasny just filed a 13G (indicating a passive stake) in TTI and a 5.3% investment. Acquiring 4.3 million shares of TTI is quite a trick, considering their average daily volume of under 1 million shares.

Other activist-owned stocks of interest to us that were recently in the news include Dow Chemical (DOW), which last week announced the sale of its chlorine business (DOW shareholders will own 50.5% of the resulting chlorine business with Olin Corp). Hedge fund Third Point has been a long-time advocate for value-enhancing moves. Another is Hertz (HTZ), which is owned by a virtual who’s who of hedge funds including funds run by Carl Icahn, Larry Robbins, Jeffrey Tannenbaum and Barry Rosenstein. HTZ has been recovering from some self inflicted wounds including accounting mistakes, poor pricing strategy and the relocation of its headquarters to Naples, Florida so as to be close to the (now former) CEO’s golf club. The persistent lethargy in HTZ’s stock price shows that it takes more than four activist investors to raise the price. However, moves in recent months to hire new management are positive signs. Today Morgan Stanley lifted its sell recommendation.

We are invested in TTI, DOW and HTZ.

We’ve long advocated investing in the General Partners (GPs) of Master Limited Partnerships (MLPs) rather than the MLPs themselves. Most importantly, the GPs have preferential economics in the form of Incentive Distribution Rights (IDRs) which entitle them to up to 50% of the Distributable Cash Flow (DCF) the underlying MLP generates. This entitlement is immune to additional issuance of equity, so GPs in effect maintain their economic stake even while the MLP grows its asset base funded with new issuance of equity and debt. In this way, MLP GPs are like hedge fund managers, in that asset growth always benefits them economically. MLP LP unitholders are similar to hedge fund investors in that asset growth may benefit them depending on the return on those additional assets.

MLP sponsors have long recognized  the benefits of the GP. It’s most powerfully illustrated in the chart at left (source: SL Advisors) showing insider ownership of GPs versus the underlying MLP. By a factor of 28:1 the money invested by the people who run MLPs favors GPs over the underlying MLPs. Not every MLP has a GP. Some have bought their GP back, creating a single class of equity. But where an MLP has a GP, if you invest in it you’ll most likely be aligning your interests with the insiders. By a factor of 28:1.

Master Limited Partnerships (MLPs) performed poorly last week, with the Alerian Index dropping 4.3%, bringing it to -7.7% YTD.  The yield on the index is now around 6.4%, 4.3% above the ten year treasury which is historically an attractive level. There were a couple of unusual financing transactions undertaken by MLPs over the past week. One was the issuance by Kinder Morgan (KMI) of Euro-denominated debt. They issued €1.25BN divided between seven and twelve year maturities. KMI has no natural need for Euros since their business is all in North America, and because they don’t operate there one might think that European investors wouldn’t be that familiar with them as an issuer. Nonetheless, KMI was able to issue seven year debt at 1.50% and 12 years at 2.25%. These yields are lower than what they’d pay in the U.S., and while it’s tempting to suggest that the declining € was an additionally attractive feature (since if the € is weaker against the $ when the debt matures that will create a further gain for KMI), such transactions typically involve a currency hedge, since KMI’s business is about running pipelines not speculating on FX rates.

But even with the hedge, it likely represents attractive financing for KMI and reflects a positive view of their investment grade debt outside the U.S.

Another unusual piece of financing came from Targa Resources Corp, (TRGP). TRGP controls Targa Resources Partners LP (NGLS), and while equity is normally issued at the MLP level, in this case the C-corp which owns the General Partner (GP) and Incentive Distribution Rights (IDRs) for NGLS carried out a secondary. They raised $292 million which could increase to $336 million if the underwriters exercise their 30 day option to buy additional shares. In effect it increased the stock component of TRGP’s earlier purchase of Atlas Pipeline Partners and Atlas Energy which closed at the end of February. Pure-play GPs need never issue equity because they don’t have any assets to finance. However, TRGP is a C-corp that owns and controls physical assets in addition to NGLS’s IDRs. As a result of the additional equity, TRGP’s Debt/EBITDA will come down to a pretty conservative 2.9X since they’ll use the proceeds to pay down part of the revolver that helped finance the Atlas acquisition.

The other bit of news was that the IRS will once again begin issuing Private Letter Rulings (PLRs). A company contemplating dropping assets into an MLP structure can approach the IRS and request a specific ruling on whether the proposed transaction will qualify as an MLP. The IRS had stopped issuing these almost a year ago so it could review the law and come up with coherent regulations to guide its decisions. The resumption of MLP related PLRs will be welcomed by companies whose planned drop-down transactions had been on hold during this period of time. In our view the trend had previously been towards a somewhat more liberal interpretation of the types of assets eligible to be placed in an MLP structure. So far there’s been no indication from the IRS about the results of their 11 month internal deliberations, so we’ll find out as new transactions are made public.

We are invested in KMI and TRGP.

Tetra Technologies (TTI) is a small oil and gas services company. Small cap energy was perhaps the least pleasant place to be invested since last Summer, and TTI’s stock duly fell from $13 last Summer to $5 recently (it closed on Friday at $5.38). TTI owns 42% of Compressco LP (CCLP), an MLP that provides compression services all along the natural gas value chain from the wellhead to gathering and processing, storage and distribution. The value of TTI’s LP interest in CCLP is $230MM based on Friday’s market prices. However, TTI also owns the General Partner (GP) for CCLP. Although the GP Incentive Distribution Rights that TTI received was less than $1MM in 2014, CCLP’s growing cashflows will soon be lifting TTI’s split up towards the 50% maximum of CCLP’s Distributable Cash Flow (DCF). CCLP has a conservative 1.7X coverage on its distribution. But based on the outlook for its DCF growth, we think these IDRs could soon be generating $20MM annually for TTI. Applying a 30X multiple (a reasonable assessment for GP IDR cashflows) values just TTI’s GP interest in CCLP at around $575MM. That’s without including any value for the 42% of LP units that TTI already owns, or TTI’s other energy services businesses. TTI expects its LP interest in CCLP to generate $32MM in DCF in 2015. This is worth $400MM, or $5 a share at TTI’s multiple or at CCLP’s current price, which seems undervalued with an 11% yield and 1.7x coverage, $244M  (about $3 per share of TTI).

TTI’s current Enterprise Value (EV) is $834MM and its market cap is $432MM. GAAP accounting requires that TTI consolidate CCLP’s debt on its balance sheet although CCLP’s debt is not guaranteed by TTI. On this basis TTI’s EV is $1.3BN, and likely makes TTI’s balance sheet appear more leveraged than it will soon when the GP IDRs start generating more cash.

TTI has a legacy E&P business (Maritech) that has been a significant drag, but they should be finished with its remaining liabilities this year. The rest of TTI’s business should be able to generate around $80MM in free cash flow annually. We think we could be close to an inflection point in CCLP’s ability to generate increasing cashflows which will reveal the value in the IDR’s TTI owns as they move up to higher splits. We think TTI has substantial upside from current levels. Although TTI is not traditionally regarded as an MLP GP, much of its potential upside comes from that element of its valuation.

Another interesting transaction that took place earlier in the week concerned the acquisition by Western Gas (WES) of Anadarko’s (APC) 50% interest in the Delaware Basin JV gathering system. APC is WES’s sponsor. What’s unusual about this deal is WES doesn’t have to pay for the assets it’s acquiring until 2020. At that time, it will pay eight times average 2018-19 EBITDA less capex. WES will receive cash from its newly acquired assets immediately, and of course so will Western Gas Equity Partners (WGP), the GP of WES that is still 88% owned by APC. Paying for something in the future at a reasonable multiple based on its performance while enjoying cashflows immediately doesn’t happen every day, and in this case required the benevolent control of WES by APC. WGP benefitted without having to contribute any capital to the transaction, once again illustrating the power of the GP.

We are invested in TTI and WGP.