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Equities Rapidly Price A Pandemic

S&P earnings are estimated to be +8% this year, according to Factset’s most recent publication. The sharp sell-off in stocks last week shows that markets are looking ahead to revised guidance. Covid-19 is a true black swan event that is challenging people to assess its impact. For example, my daughter just canceled a Caribbean cruise because she has three young children, including a four month old. The cruise line’s “Coronavirus update” spooked her, even though it only applied to Asia. My nephew, a UK-based virologist sequestered to work on the virus, advises that we will adapt to a new, seasonal flu for which annual vaccinations will eventually be available. A week ago I bought some face masks on Amazon.

In an abundance of caution, 14% of regular drinkers of Corona beer are shunning the beverage. Since comparing the fatality rate of Corona with coronavirus is a few clicks away on a smartphone, employed Corona drinkers likely exhibit limited mental dexterity.

Covid-19 is both more infectious and deadly than the seasonal flu, with a fatality rate that is estimated at 2-4% for Hubei Province where it started, and 0.5-1.0% in other parts of China. Locking down entire cities, as the Chinese government has done, promoting “social distancing,” and numerous canceled sporting events all hint at severe economic disruption. The results will show up in most corporate earnings reports for this quarter and possibly beyond. The S&P500 moved from another record high to a 10% correction in just six sessions, the fastest in history. On Friday it closed 12% below its February 19 high.

Crude oil fell $8 per barrel, dragging the S&P Energy ETF (XLE) down 17%, and the rest of the sector with it. Unlike the S&P500, XLE was not retreating from a recent all-time high either. The attractive yields on pipeline stocks offered only modest valuation support, with the American Energy Independence Index (AEITR) falling 14% from its February 19 recent high.

We updated our Equity Risk Premium (ERP) model to offer a guidepost in all the uncertainty. In December, we noted that the spread between the earnings yield on the S&P500 and ten year treasuries (the ERP definition) still favored stocks, but not as much as it had in the past. We also pointed out that fixed income buyers were keener to invest in energy infrastructure than stock investors (see Pipeline Bond Investors Are More Bullish Than Equity Buyers).

Today’s investors in stocks confront substantial near term uncertainty and the possibility that extended economic disruption will lead to a recession, a warning offered by ex-Fed chief Janet Yellen.

At its recent peak on February 19, the ERP was at 4.2. Following the recent drop, assuming 2020 earnings are flat rather than the +8% from Factset’s forecast, equity valuations are roughly unchanged with an ERP of 4.5.

The problem is that it’s still difficult to assess the earnings hit covid-19 will cause. Economic activity in China appeared to collapse, with coal consumption 40% below normal. Japan has closed all its schools until early April, affecting 13 million students. The U.S. Center for Disease Control (CDC) described the potential public health threat as high, both globally and to the United States. We can imagine the consequences of a U.S. region or major city confronting an outbreak.

A 20% drop in earnings would exceed the 2008 financial crisis. A very severe covid-19 recession in the U.S. would be required to cause this kind of fall in profits. The ERP might not be many people’s first thought in such an outcome, but suffice it to say that stocks aren’t cheap if you rate this as a real possibility.

Although crude oil’s fall in response to economic weakness has hurt energy infrastructure stocks, we continue to expect substantial growth in free cash flow this year and next. Other than Cheniere Energy, who have seen a couple of shipments of liquefied natural gas cancelled, the virus has had very limited impact on the sector’s outlook. The components of the AEITR yield 8.2%, with mid-single digit percentage dividend increases expected for the next several years.

We are invested in all the constituents of the American Energy Independence Index, which includes Cheniere Energy, Inc.

 




Coronavirus Dominates Thoughts on Cheniere

Few sectors are immune from coronavirus fears, and energy is no exception. Although U.S. midstream energy infrastructure is overwhelmingly domestic, growing oil and gas exports have increased business sensitivity to global export demand.

Liquified Natural Gas (LNG) prices for Japan and South Korea (the Japan/Korea Market, JKM) have fallen dramatically in recent months. This was initially driven by weak U.S. prices because of the glut of domestic natural gas. Softening demand due to coronavirus has added to this.

Consequently, Cheniere Energy Inc. (CEI) had fallen more than most, down 16.7% YTD through Monday prior to earnings, and substantially worse than the American Energy Independence YTD at -6.5%. CEI has always asserted that their business model limits their exposure to LNG prices, since they typically don’t take delivery. Nonetheless, canceled shipments and softening demand would still be expected to hurt.

So CEI’s earnings, released yesterday morning, provided a welcome confirmation of their business model’s resiliency. 4Q EBITDA of $987MM beat expectations, and was +56% Y-O-Y. CEI dispatched 429 cargoes last year, +57% versus 2018.

Coronavirus wasn’t a factor in 4Q earnings, so investors were more interested in the outlook. Although CEI reaffirmed 2020 EBITDA guidance, at $3.8-$4.1BN, in their comments they noted it was tracking towards the lower end of the range. LNG shipments are similar to pipeline take-or-pay contracts, in which shippers have to pay for capacity whether or not used. For now anyway CEI expects a muted impact over the full year, although they did note two April shipments had been cancelled. Asia used to dominate LNG trade, but last year European provided most of the demand growth, reaching 50% of all U.S. LNG exports in 4Q19.

On the earnings call, CEO Jack Fusco noted several highlights, including their 1,000th LNG cargo. It took less than ten minutes to get to the ESG slide – Fusco correctly noted that switching from coal to natural gas for power generation is one of the most meaningful steps countries can take to lower CO2 emissions. China, which burns half the world’s coal, is where such efforts must start.

CEI’s stock opened higher, but slid during the day on comments from the call as well as the market’s broad-based slump. It’s still too soon for investors to look at fundamentals; coronavirus dominates every move.

 

 




Pipeline Earnings Offer Helpful Insights

Earnings season for pipeline companies is drawing to a close, with just a few more names left to report. Results have been mostly as expected with a couple of surprises. Targa Resources (TRGP) handily beat expectations for 4Q19 EBITDA at $465MM versus $362MM. CEO Joe Bob Perkins drew criticism last year for his flippant comment about “capital blessings” when responding to investor questions about growth capex. A charitable assessment of TRGP’s capital allocation would concede that they embrace investing for future cashflow more than most of their peers. However, it does look as if they’re in the middle of a big swing in Free Cash Flow (FCF) 2019-2021. Following earnings, TRGP jumped 7%.

Energy Transfer (ET) reported another strong quarter and guided long term growth capex down to $2.0-2.5BN. 2018 FCF was ($412MM), and this year it should come in above $2.5BN, illustrating the very positive FCF improvement across most of the industry as financing of growth projects recedes. ET was also ready for the predictable question on structure – a “c-corp option” was their response, presumably meaning they’ll create a 1099-issuing entity that holds ET units. This will broaden the investor base but leave whatever concerns investors have about governance unresolved – by offering investors a c-corp without traditional corporate governance, its price may shed some light on the valuation discount partnerships endure.

Williams Companies (WMB) reported in-line earnings, but the conference call offered some useful insights. Upstream companies (i.e. oil and gas producers) are the customers of midstream energy infrastructure, and E&P bankruptcies often cause concern that pipelines will be left stranded, running to wells that no longer produce. WMB CEO Alan Armstrong had this to say,

“After a very long time in this midstream business, I have seen and experienced many instance of producers’ stress and even bankruptcy, and it’s very clear to me that the most protected service by far is that a wellhead gathering. Wellhead gathering is absolutely essential to any reserves that are going to be produced. Gas could not get to market and cash flow cannot be realized, if wellhead gas gathering is not available.

“While counterparty credit is important, the physical nature of the service is even better security.”

History has shown that in general an E&P bankruptcy just leads to a change of ownership – initially often the bondholders as equity is wiped out. Where production covers operating costs but earns an inadequate return on capital, the drilling lease was purchased at too high a price with excessive debt. Bankruptcy alters the capital structure. Pipeline operators are generally kept whole.

On another topic, opposition by environmental extremist to new pipeline construction represents an undemocratic effort to achieve what they’ve failed to democratically. For an investor interested in FCF, making pipelines harder to build lowers growth capex, leaving more cash to be returned to investors. So while pipeline opponents betray only a passing familiarity with how modern civilization functions, their wrongheaded moves aren’t necessarily unfriendly to investors.

Making new pipelines harder to build can also increase the value of existing ones. Alan Armstrong had this to say about Transco, WMB’s extensive natural gas pipeline network:

“The forces you see working in the market today are only increasing the competitive advantages of Transco. Low prices continue to incent demand in all sectors, and our access to many geographies and types of demand is unmatched. LNG, industrial, power, residential, commercial are all growing along Transco.

“Difficulties seen by Greenfield pipeline projects will also benefit Transco in the long run, as Transco has uniquely positioned to meet new capacity demand by expanding along its existing rights of way, which are irreplaceable and unmatched in terms of their proximity to demand.”

As we’ve mentioned in the past, growing FCF remains the strongest reason to invest in pipelines. Last year the two big Canadians, TC Energy (TRP) and Enbridge (ENB) were half the FCF of the sector as defined by the broad-based American Energy Independence Index. Consequently, TRP and ENB both outperformed the S&P500 in 2019, providing solid evidence that strong operating performance trumps any investor aversion to the energy sector.

This year the two Canadians’ share of FCF should drop if, as we expect, other companies finally start to emulate them.

We are invested in all of the names mentioned above.

 




Kinder Morgan Responds to our Recent Criticism

To their credit, Kinder Morgan (KMI) responded to our recent blog (see Kinder Morgan’s Slick Numeracy). We exchanged several emails, although they declined our invitation to write a rebuttal which we promised to publish unedited. The company stands by their presentation, but did concede that some slides might have been more clearly labeled.

We had noted in our blog that the 5.9X EBITDA multiple on $12.3BN invested didn’t foot to the $1.8BN EBITDA from growth projects in the Bridge Chart. KMI explained this was because some investments they made had been sold in the meantime.

They believe that attractive returns on more recent investments have been masked by headwinds in their existing business. The EBITDA Bridge Chart blames the 2014-17 energy downturn for $0.6BN in reduced EBITDA from their CO2 business, which is net of new investment (i.e. CO2 growth projects are included in this figure). The $0.3BN drop in the Midstream segment was from lower volumes and tariffs in their pipelines.

KMI’s return on invested capital has drawn questions from others. A January 6 research report from Morgan Stanley placed KMI’s 2017-18 Return on Invested Capital (ROIC) at 4.5%, worst out of 12 peers. In October, Wells Fargo calculated a 2013-18 cash return on investment of 4%, 2nd worst in the group and declining.

In response, KMI referred us to a slide showing ROIC by segment. They say they have discussed the Wells piece with the firm, and make a distinction between recently invested capital and returns on legacy assets.

The ROIC slide incorporates some complexity. The footnote reminds that pre-2014 returns are from Kinder Morgan Partners (KMP) and El Paso (EPB), which is where KMI’s operating assets were held before being rolled up into the parent. Those were the days of Incentive Distribution Rights (IDRs), when KMP and EPB both paid a share of their returns back to their controlling general partner, KMI.

Once the IDRs went away, returns might have been expected to jump. That they didn’t suggests that the chart treats IDRs as a cost of capital and not as an expense to KMP and EPB, which they most assuredly were. So we think the returns are on the assets, not on what KMP and EPB unitholders earned on those assets.

KMI believes they are making a genuine effort to present their case, and in providing so much detail they create opportunities for investors like us to look for inconsistencies. But we think that EBITDA multiples aren’t a good way to do it. The declining ROIC chart is hard to reconcile with higher recent returns. It also highlights the volatility of the CO2 business, which they evidently believe can get back to the returns it generated a decade ago. The fact that they haven’t yet received a sufficiently attractive offer for this segment means few share their optimism.

The company uses IRR in allocating capital. They say new projects require unlevered pre-tax returns of 15-20%, but their ROIC chart shows returns sliding towards 10%. At some point the high return investments of recent years must lift their overall ROIC. EBITDA multiples can flatter – a project with declining EBITDA (like a CO2 investment) might look superficially attractive based on Year 2 returns but ultimately not cover the cost of capital. The company is adamant they’re not allocating this way. So why not show expected IRRs on new investments?

We appreciate KMI’s effort to reach out – “slick numeracy” probably didn’t gain us any additional friends there. Along with countless other long-time investors, we’re frustrated that KMI remains well below the highs of 2014. Their stable, fee-generating assets ought to draw a higher valuation.




Gulf Tensions Back in Play

Just over three months ago, Saudi Arabian oil facilities were put out of action by a drone and missile strike. Oil prices jumped. It seemed indisputable than Iran was behind the attack – the sophistication was beyond that believed available to the Yemeni Houthi rebels who claimed responsibility. Saudi retaliation appeared inevitable, as half their oil production was taken offline.

Crude jumped, but the Saudis chose to ignore Iran’s provocation. Prices soon fell back as the market resumed its sanguine view of supply disruption.

So is it different this time? The assassination of Iran’s top military leader, General Qassem Soleimani, looks like a sharp escalation of tensions. Secretary of State Mike Pompeo justified it as preventing “an imminent” attack on U.S. citizens. Reportedly, both Presidents Bush Jr and Obama declined opportunities to kill Soleimani in the past, because they feared it would lead to war. Iran has so far pursued asymmetry, avoiding a hopeless direct military confrontation in favor of indirect responses under cover of plausible deniability. Will that strategy change?

The Shale Revolution affords the U.S. far more foreign policy flexibility, now that OPEC can’t cause lines of cars at gas stations. Substantially higher domestic production of hydrocarbons made America a net exporter of crude oil and petroleum products late last year. Qassem Soleimani might be alive today if not for fracking.

Near term bets on crude oil or the energy sector will turn on how events play out, and it’s easy to have misplaced conviction with so many possible scenarios. Exxon Mobil (XOM) operates in 38 countries. Some of their infrastructure, which includes three JVs in Saudi Arabia, may be vulnerable, Geopolitical risk comes with complexity.

This is not the case for U.S. midstream energy infrastructure. For this sector, “international” is limited to Canada and in some cases Mexico. Pipelines are hard to damage because they’re underground, and while aboveground facilities are certainly more vulnerable, America is not an easy place for terrorist operations.

The sector is cheap enough that an investor can awaiting a re-pricing catalyst, which could be conflict in the Middle East or simply the market’s ultimate recognition of improving fundamentals.

Although S&P500 valuations are historically high, at over 18X 2020 earnings, the five biggest North American midstream infrastructure names trade at almost a 20% discount. All five of these companies are in the American Energy Independence Index.

S&P Energy, having sunk to 4% of the S&P500, is at close to its cheapest relative multiple in a decade.

There’s no need to correctly forecast disruptive geopolitical events or react quickly to them. Pipeline stocks are cheap enough to provide holders with multiple potential ways to make money.

We are invested in all the names listed above.




News on our American Energy Independence ETF (USAI)

Last week shareholders of the American Energy Independence Fund (USAI) approved its reorganization into the Pacer American Energy Independence Fund. Today, Pacer took over from SL Advisors as the fund’s advisor.
We expect that this will allow Pacer Advisors to leverage its resources for and focus its marketing and distribution efforts on growing USAI’s AUM.
Please click here for more information.



Should Closed End Funds Use Leverage?

Closed end funds (CEFs) are an obscure sector of the market with a small but fiercely passionate following. Because they have a fixed share count, they can trade at a premium or discount to the value of their holdings, which are usually public equities or debt.  This creates appealing opportunities to buy at a discount to intrinsic value. Closed End Fund Advisors provides a lot of useful information on the sector.

Liquidity is always a problem, so the investors tend to be retail with a small handful of institutions. It can sometimes take several days to get into or out of positions. We occasionally run across financial advisors who invest in CEFs for their clients.

In theory, CEFs should generally trade at a discount to Net Asset Value (NAV), because of their relative illiquidity compared to the basket of underlying shares. MLP CEFS have an especially interesting history. We often note the terrible tax structure of the Alerian MLP ETF, AMLP (see MLP Funds Made for Uncle Sam). But MLP CEFS pre-date AMLP and provided some justification for its launch.

This is because for many years MLP CEFs consistently traded at a premium to NAV. The Kayne Anderson MLP/Midstream Investment Company (KYN) illustrates this point. For most of its history, KYN shares have traded at least 5% higher than NAV and at times over 30%. MLP CEFs possess the same tax inefficiencies as AMLP, in that they are liable for corporate taxes because they are more than 25% invested in MLPs.

The benefit of the tax drag is that KYN investors get exposure to MLPs without the tax hassle of K-1s for tax reporting. A decade ago, investors clearly placed a high value on this simplified tax reporting, as evidenced by the substantial premium to NAV at which KYN traded. AMLP’s 2010 launch took place against this backdrop of strong demand for the tax-burdened, 1099 structure.

Where KYN and other MLP CEFs differ from AMLP is in their use of leverage. This is common in CEFs and supports higher yields in exchange for increased NAV volatility. In addition, the interest expense lowers taxable income, which can lower the inherent inefficiency of an MLP CEF with its corporate tax obligation.

For the past year, KYN has traded at a discount to NAV averaging almost 10%. It’s another symptom of declining retail interest in the sector. The sharp 2014-16 drop with heightened volatility caused some damage.

It’s worth revisiting the use of leverage by MLP CEFs. To continue with KYN, in reviewing their past financials, they seek to stay close to “400% debt coverage”, meaning that their desired portfolio consists of $400 in investments funded with $100MM in debt and $300MM in equity. So $1 invested in KYN controls $1.33 in MLPs. The 400% debt coverage rises and falls with the market. Rebalancing back to their target requires selling after a market drop, and buying following a rally (i.e. buy high, sell low). KYN tends to move a little more than the market as a result.

The question is, whether such leverage continues to make sense. MLP balance sheets have come under a great deal of scrutiny in recent years. The industry has moved towards self-funding growth projects with less reliance on external financing; higher distribution coverage; less leverage. Investment grade companies now target around 4X Debt:EBITDA.

A portfolio of MLPs is pretty concentrated. An investor in KYN or other MLP CEF, by accepting leverage at the CEF level, is implicitly rejecting the industry’s 4X Debt:EBITDA target as needlessly conservative. Is this a smart decision? It might make sense to add leverage to a diversified portfolio, because the low correlations across pairs of individual names will keep the portfolio’s volatility below that of its average holding. But if you’re invested in a single sector, the average volatility of the holdings will come close to your portfolio’s volatility. Adding leverage to that portfolio increasingly looks like adding more debt to each individual holding. The practical result is that the investor is adding more risk than the company and credit rating agencies deem appropriate.

We don’t use leverage in our business. The sector has been volatile enough in recent years, and the periodic rebalancings that are required tend to force you to buy high/sell low.

In KYN’s most recent quarterly financials (August 31), they noted 401% debt coverage versus their target of 400%. Since August, the Alerian MLP index (AMZX) has dropped 10%, implying KYN’s coverage ratio has sunk to 360%. Restoring their 400% target coverage will have required selling over $110MM in securities, adding to the market’s recent selling pressure. Last year’s 4Q saw a 17% drop in AMZX which was almost certainly exacerbated by MLP CEFs delevering. The rebound earlier in the year would have seen MLP CEFs similarly increasing leverage back up.

MLP CEFs are constantly chasing the market to restore their desired leverage. Higher volatility increases the cost of such frequent portfolio rebalancings. We think it’s time their investors reassessed whether accessing the sector with leverage makes sense.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 




When Will MLPs Recover?

Our blog topics are often informed by the subjects that come up in conversations with clients. October was a wrenching month, with the Alerian MLP index slumping to -6% versus +2% for the S&P500. MLPs have lagged equities by an astonishing 22% YTD. Over the last couple of weeks we have been busier than usual fielding calls from investors. By far the most common question in various forms is, when will MLPs recover?

So, for the benefit of those with whom we haven’t recently chatted but are wondering the same thing, below we summarize our thoughts:

  • Energy sector sentiment. This remains terrible. Investors would still prefer more disciplined capital allocation. Management teams too often seek dilutive growth, often because their compensation isn’t aligned with per-share metrics.
    Midstream energy infrastructure has handily outperformed the E&P sector this year, and capital discipline is improving. But many of the people we talk to are weary, looking for reasons to remain invested and searching for confirmation in their original investment thesis that increasing production should benefit pipelines with their toll-like model. However, there are positive signs here, in that Free Cash Flow for midstream energy infrastructure is set to soar over the next couple of years (see The Coming Pipeline Cash Gusher). Growth capex peaked last year, and existing assets are generating more cash. These are both driving FCF to almost $10BN this year, $27BN next year and $43BN or so in 2021. Recent quarterly earnings generally provided confirmation of this positive trend. For example, Targa Resources (TRGP), one of the worst offenders, has 2020 investment spending plans of $1.2BN, half of this year’s. Former CEO Joe Bob Perkins flippantly talked about new projects as “capital blessings”. Investors won’t miss his self-serving arrogance.
  • Retail investors are selling. Approximately $3.6BN, roughly 7% of the total, has left MLP mutual funds, ETFs and related products in the past twelve months, which creates constant downward pressure on prices. Although our own products have seen net inflows this year, this is not the norm.
  • The MLP business model is probably dead. Pre-2012, pipeline companies organized as MLPs and paid out 90% or more of their cashflow. Back then, America obtained its oil and gas from roughly the same places in the same amounts year after year. Few new pipeline projects were needed, so with little need to retain cash MLPs offered high yields. These attracted income-seeking investors who, because of the K-1s that MLPs issue, tended to be wealthy. In other words, old, rich Americans. The Shale Revolution offered up oil and gas in places not traditionally served by infrastructure – for example, the Bakken in North Dakota and the Marcellus in Pennsylvania. The Permian in west Texas, although long a producing region, saw significant increases in volume. MLPs decided to invest in new pipelines, pressuring balance sheets and ultimately sacrificing distributions. Kinder Morgan was the first to slash its payout, before ultimately simplifying its structure as Kinder Morgan Inc (KMI) absorbed the assets of its MLP, Kinder Morgan Partners (KMP). The rationale for becoming a corporation was to access capital from the world’s institutional equity investors rather than just the old, rich Americans who buy MLPs (see Kinder Morgan: Still Paying for Broken Promises). Most institutions avoid publicly traded partnerships because of complex tax considerations. In the process, original KMP investors, who had invested for stable tax-deferred income, suffered two distribution cuts and a taxable transaction when their units were swapped for shares in KMI. Many thousands remain bitter to this day.  Rich Kinder’s promise of ever rising distributions fueled higher payouts back to his general partner via Incentive Distribution Rights (IDRs).
  • Prior to 2014, many investors viewed the distribution as sacred and assumed that Rich would honor his promise to continue paying them.  After realizing they’d been duped into essentially transferring their money to Rich Kinder through this IDR mechanism based on broken promises, they’ve understandably become disillusioned.  If you run into a former KMP investor, ask about their betrayal by Rich Kinder. It’ll be a colorful story.  Other MLPs followed KMI’s lead. MLPs shed their income seeking investor base in their desire to fund growth projects. More distribution cuts and unwelcome tax bills followed. This transition to institutional, total return investors has been far harder than they assumed. The legacy of betrayal continues to hang over the sector. KMI had a slide titled “Promises Made, Promises Kept”, boasting about their 13 years of distribution growth.
    The Alerian MLP ETF has cut its distributions by a third, reflecting similar cuts by its underlying components. This is the only time we’re aware of in which companies slashed distributions even while operating performance was fine, as shown by the growing EBITDA on the slide below.
    EBITDA vs Leverage
    But if you’ve invested for the income and it’s cut, you’re let down and no mitigating circumstances will compensate. It’s why MLPs have shrunk to well under half the midstream energy infrastructure sector, with conventional corporations (“c-corps”) now dominant.
    Investors in MLP funds or MLP-only portfolios can select from a couple of big MLPs and many very small ones while overlooking six of the ten biggest pipeline companies, since they’re corporations. AMLP, with its 100% MLP construction and disastrous tax structure, would never be created in today’s form. It is a slowly shrinking legacy to the past (see MLP Funds Made for Uncle Sam).
  • Election year concerns. A Warren victory is perceived as the most negative, due to her proposed ban on fracking. If applied to federal lands this would have some very modest impact on production. Most drilling takes place on private lands and is regulated by the states. An outright ban on fracking would require an act of Congress which, barring a complete Democrat sweep to include control of the senate, we believe is highly unlikely.
  • Tax loss selling. This seems to happen every year, but energy’s chronic underperformance has created opportunities for investors to pair gains elsewhere with losses in this sector.
  • Climate Change. It’s hard to assess the impact of investors who might otherwise invest in energy declining to do so, either for ESG reasons or because they fear public policy will impose harsh limits on use of fossil fuels. ESG funds are notable investors in some of the biggest pipeline corporations but not in MLPs because governance (the “G” in ESG) provides weaker investor protections. Tallgrass recently demonstrated this (see Blackstone and Tallgrass Further Discredit the MLP Model). The result has been that the MLP-dominated Alerian MLP index has increasingly lagged our own American Energy Independence Index, which is 80% corporations.

Our best bet is that tax loss selling will soon abate, and continuing evidence of capital discipline will draw generalist investors to invest. There’s certainly plenty of interest from other buyers (see Private Equity Sees Value in Unloved Pipelines). But the history of distribution cuts, some poor capital allocation decisions and episodes of investor abuse because of weak MLP governance have depressed sentiment for some time.

For many years November was the best time to buy, with the predominantly retail investor base making the January effect more pronounced than in the broader equity market. The effect has become more muted as companies have switched from MLP to corporation, but still remains a factor (see Give Your Loved One an MLP This Holiday Season) 

We are invested in KMI and TGE




Energy Transfer’s Weak Governance Costs Them

Three years ago, Energy Transfer Equity (then ETE, now ET following its 2018 simplification) cleverly extricated itself from a ruinous attempted acquisition of Williams Companies (WMB). Having relentlessly pursued his target, ETE CEO Kelcy Warren came to regret the terms he’d offered as rating agencies criticized the overly leveraged contemplated combined entity.

Having failed to renegotiate, ETE’s lawyers ingeniously devised a special issue of securities restricted to ETE management. By diluting the subsequent value of ETE units, it had the effect of lowering the value of the proposed combination to WMB shareholders while protecting ETE insiders against any dilution (see Is Energy Transfer Fleecing Its Investors?). Convertible preferred securities were issued to approximately 31% of ETE’s unitholders (that being the portion held by management), that allowed its dividend to be reinvested in new ETE units at a low price only briefly touched. Most ETE investors would likely have invested in such attractive securities had they been more widely offered. But WMB opposed their wider distribution, as they were allowed to under the terms of the merger proposal, predictably since they recognized the dilutive effect of their issuance.

Ultimately, ETE was able to extricate itself by noting unfavorable tax treatment that would diminish the transaction’s value. The convertible preferreds, originally believed by many to exist solely as a means of destroying the deal’s value to WMB shareholders, remained following its cancellation. Thus did Kelcy Warren cement his reputation as a CEO willing to unethically extract value from his fellow owners when such opportunities present themselves.

A class action lawsuit was filed, and ETE successfully defended itself. The law was on its side, even though many investors felt cheated.

It’s interesting to look back over the three years that have passed and assess whether Kelcy’s reputation for self-dealing remains a burden on Energy Transfer (now ET following its simplification).

Operating performance remains strong. ET regularly beats expectations for quarterly earnings but its stock remains stubbornly undervalued (see Why Energy Transfer Can’t Get Respect). Earnings calls often include questions on what ET can do to get the stock higher, with Kelcy lamenting the market’s lack of appreciation for his team’s value creation.

By most measures ET is attractive. It offers a 9.6% yield, almost 2X covered by Distributable Cash Flow (DCF). Leverage is coming down and their growth projects are self-funded, meaning there’s no additional sale of equity to raise cash.

Master Limited Partnerships (MLPs) offer weaker governance protections to investors than corporations. Tallgrass Equity (TGE) recently demonstrated this when Blackstone’s (BX) offer to acquire the 56% of the company they don’t already own drew attention to a sideletter providing a higher sale price of TGE stock held by management in such an eventuality (see Blackstone and Tallgrass Further Discredit the MLP Model). TGE CEO David Dehaemers showed that the acquisition of a publicly traded partnership doesn’t require a big control premium paid to all the owners – only to management.

It struck us, and ought to assault the sensibilities of every asset manager who owns TGE, that the CEOs of publicly traded partnerships are spectacularly unconstrained by the ethical standards  followed by the people who buy their stock. We invest alongside our clients like most CEOs, but the notion of selling our own shares in a jointly held position higher than our investors is unfathomable, and illegal. Evidently not so for TGE. Whether the BX deal is accepted or modified in some way to try and assuage the appalling optics, Dehaemers has joined Kelcy Warren in ignominy.

It’s become clear that weak governance is affecting the value of some MLPs. A few management teams are trusted to deal fairly, but ET may inadvertently be a casualty of TGE’s demonstration of who holds the high cards.

ET’s stock looks like a bond at the bottom of the capital structure. It pays a high yield easily supported by cash flow, but its holders (being equity investors) have no class of investor beneath them. The upside opportunity that usually compensates equity holders is denied ET investors, because in any sale of ET they should expect the control premium will somehow accrue only to management and not to all ET equity holders. TGE has shown how it can be done.

We calculated that ET insiders transferred over 1.3BN in unethical value to themselves through the convertible preferreds in 2016. However, given ET’s relative performance since then, it looks like a Faustian bargain. They’ve dissuaded investors whose purchases might have driven ET’s yield down by the 3% or so that would equate its valuation more closely with Enterprise Products Partners (EPD), another big MLP but without ET’s history. That would reprice ET stock 50% higher. The management’s team’s 13.5% stake (now lower, since the 2018 simplification resulted in a larger company) would be worth an additional $2.2BN, So the valuation haircut on management’s holdings is more than the 2016 transfer of value. Kelcy’s dubious ethics have burdened ET’s stock for the worse, costing everyone, including the people running the company.

We are invested in ET and EPD




MLPs No Longer Represent Pipelines

As recently as five years ago, the terms “MLPs” and “pipelines” were interchangeable. If you wanted to invest in pipelines for their steady growth and attractive tax-deferred yields, you had little choice but to be a K-1 tolerant, MLP investor. MLP-dedicated funds were developed to provide retail exposure to the sector, but the corporate tax burden has contributed to their disappointing performance (see MLP Funds Made for Uncle Sam).

A far bigger contributor to poor performance has been years of distribution cuts to fund growth (see It’s the Distributions, Stupid). Income generating businesses became growth-seeking, as the Shale Revolution drove the industry to reinvest more of its cash in infrastructure. America’s energy renaissance broke the MLP model.

This has led to a steady diminution of the importance of MLPs to the midstream energy infrastructure sector, since many of the biggest have converted to be corporations (“c-corps”). This makes them available to a far wider pool of investors than MLPs, which still generally struggle to attract significant institutional support.

One consequence is that the Alerian MLP Index (AMZX) is becoming steadily less representative of midstream. This is why two years ago we created the American Energy Independence Index (AEITR), recognizing that MLPs are only part of the story. AEITR limits partnerships to 20%, reflecting their diminshing importance and allowing investment products linked to it to be fully RIC-compliant with no corporate tax burden. AEITR also excludes MLPs that are controlled by a General Partner (GP), because of the weak rights such MLP investors have as well as the dilutive payments (called incentive distribution rights) from the MLP to the GP.

The shift to corporate form for the industry has left AMZX including only four of the ten biggest names in the sector in its index – because most of the giants are corporations. It’s also led to it being more concentrated – 70% of the index is in only ten names (versus 60% for AEITR) and 49% is in only five (versus 37%). And the market cap of the underlying names in AMZX is $257BN, only slightly more than half the AEITR’s $490BN.

Investors are increasingly shifting to broader exposure, which is why corporations have been outperforming MLPs. This is illustrated by the AEITR (80% corporations) leading the AMZX (100% partnerships) by 7% over the past twelve months.

Partnerships provide weaker protections to investors, especially on issues of governance. It’s why Energy Transfer (ET) was able to award preferential securities to management three years ago (see Will Energy Transfer Act with Integrity, written when misplaced hope remained that they might). More recently, Tallgrass (TGE) showed that it’s not above self-dealing either, when it became apparent that Blackstone’s bid to acquire the 56% it doesn’t yet own would trigger a sale of management’s TGE units at a far higher price via a sideletter (see Blackstone and Tallgrass Further Discredit the MLP Model). Asset managers observe far higher ethical standards than some public companies.

Weak governance is why many institutions avoid partnerships. A research report from JPMorgan recently noted that, “…given the proliferation of corporate governance problems in the MLP space, many generalist investors will not entertain the notion of discussing MLPs in our investor conversations.”

In 2018 there were no MLP IPOs, compared with 20 in 2013 and 18 in 2014. This year Diamondback floated a minority interest in their midstream business as Rattler Midstream (RTLR), but that company elected to be taxed as a corporation, seeking to broaden its appeal by providing a 1099. However RTLR has a partnership governance structure, which means fewer rights for RTLR investors.

Over $50BN is invested in vehicles that track MLP indices, much of it in tax-burdened funds. JPMorgan reports $2.5BN in outflows over the past year. The shrinking pool of MLPs is making them less representative, and poor performance has led to outflows, which in turn weighs on pricing.

Changing to a more representative index would require these funds to dump MLPs, which would further depress MLP valuations. As a result, Alerian continues to talk up the MLP structure with blogs such as the sycophantic TGE: Take-Private Bid Highlights Continued Private Equity Interest in Midstream. There’s no mention of the controversial sideletter noted above.

There continue to be some good MLPs, such as Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP) and Crestwood Equity Partners (CEQP). Some that are closely held see little value to incurring a corporate tax burden (see Pipeline Billionaires Cling to Partnership Model Others Shun).  ET is well run but undervalued, reflecting the perceived risk to investors of more questionable dealings by management. MLPs with a history of fair dealing receive a higher valuation than others. But poor governance remains a headwind to greater investor interest.

Surprisingly, ESG funds own several large midstream corporations including Kinder Morgan (KMI), Oneok (OKE) and Williams Companies (WMB) (see Improving disclosures is key to ESG investment in midstream, analysts say). Partnerships are not among the names held by ESG funds, because on “G” (Governance), they come up short.

Pipelines are no longer synonymous with MLPs, even though many funds behave as if they are. Fund flows and relative performance show investors are taking notice.

We are invested in CEQP, EPD, ET, KMI, MMP OKE, TGE and WMB