Reviewing The Deficit Myth
Stephanie Kelton’s The Deficit Myth opens with the startling assertion that the only reason today’s fiat currencies have any value is because citizens need to acquire them to pay taxes. Without that requirement, there would be no need to hold dollars, euros or yen. I first heard this argument from Warren Mosler twenty five years ago when he was a partner in hedge fund Illinois Income Investors in West Palm Beach. I found this view quixotic at the time, although our meeting was too brief to fully refute it. Today Mosler is regarded as the father of Modern Monetary Theory (MMT), seized by progressive Democrats as evidence that the Federal government can pay for everything.
To prove that tax liabilities are necessary to give money value, Kelton recounts a story I heard personally from Mosler in the 1990s. Suppose he assigned household chores to his children with payment promised in business cards. With little of value being offered in exchange for the work, the lawn would remain uncut and the car unwashed. But if Mosler the Dad then imposes a monthly tax of 30 business cards from each offspring, on pain of being grounded, they suddenly have value. The work gets done.
From this follows the logic that the government needs to spend money in order to provide the means with which to pay taxes. The government, as the sole issuer of currency, can pay in regular green dollars, or in yellow interest-bearing dollars (i.e. they can borrow to pay their bills). They can never run out. So they can never go bankrupt. Therefore, deficits don’t matter unless they exhaust the economy’s productive capacity, which is inflationary.
I’m still not convinced taxes are necessary to give a fiat currency value, although behind every such currency lies a government taxing and spending it. For much of human history money has been linked to gold. When the US left the gold standard in 1971, the severing of the link ushered in fiat currencies that derived their value from the issuing country’s policies. But it’s definitely clear that a country can never be forced into bankruptcy in its own fiat currency, as they can always issue an unlimited amount to pay their bills. In this narrow sense, debt doesn’t matter.
So far, this is a non-partisan exercise in economic theory.
Kelton then seizes the access to unlimited credit to gorge on a left wing dream of largesse. Trillions of dollars are breezily allocated to student loan forgiveness, upgrading our infrastructure, fighting climate change and dealing with the pandemic. Because the Federal government can never go bankrupt, deficits don’t matter. The twin looming crises of social security and Medicare don’t matter, because the government will spend whatever it needs to, since its ability to borrow in its own currency is unlimited.
It sounds implausible, but here Kelton misses the opportunity to strengthen her case. Today, America’s fiscal outlook provokes widespread hand wringing and dismay. Retiring baby boomers will command an unsustainably growing chunk of Federal spending. There is nothing remotely optimistic to be said on the topic. Yet long term government bond yields remain defiantly low. The empirical evidence that deficits don’t matter exists in Uncle Sam’s continued ability to fund its needs at rates below inflation. An even more brazen MMT advocate would argue low bond yields are the market’s vindication that deficits don’t matter.
The failure of conventional economic thinking to explain apparently costless fiscal profligacy offers at least an opening for the progressives who have hijacked MMT to drive through. Kelton misses her chance.
The risk is of course inflation. If the government tries to pay for more output than the economy is able to provide, inflation will follow. If Mosler the Dad started adding new chores, he’d have to offer more business cards per hour to motivate his exhausted children. Had his progeny begun saving these cards for the future, the resulting inflation would diminish their value. Kelton does admit to limits on spending, but these are imposed by inflation not deficits. She argues that government spending should rise until it’s inflationary, ensuring maximum utilization of the economy’s potential.
That is in effect current policy, administered by the Federal Reserve’s twin objectives of maximum employment consistent with stable inflation. Kelton would prefer the Federal government was explicitly responsible for the twin mandate rather than the Fed. In doing so they would rely on fiscal, rather than monetary policy.
Since inflation has remained so consistently low that the Fed is trying to overshoot its 2% target, it’s a reasonable argument that pursuing NAIRU (the Non-Accelarating Inflation Rate of Unemployment) through interest rate policy alone is leaving millions of potentially productive people out of the labor force. The Fed can be criticized for over-estimating NAIRU, but there’s no reason to think Congress would do any better. They would inevitably synchronize economic booms even more closely with the election cycle, and there would be no reason to expect anything but a bad outcome. This is why independent central banks are part of every well-run economy.
However, Kelton goes further, advocating government spending until everyone has a job, supported by a Federal jobs program for all. “The federal government announces a wage (and benefit) package for anyone who is looking for work but unable to find suitable employment in the economy.” she writes.
Kelton’s faith that a huge program of useful jobs could be run productively without abuse is naive. Would the government fire lazy workers? Under her approach, “It takes workers as they are, and where they are, and it fits the job to their individual capabilities and the needs of the community.”
It would descend into a jobs program for those unemployable in the private sector. Don’t MMT advocates even believe in workers learning marketable skills?
Many questions are left unanswered. Most obviously, what would the Federal government do when its spending caused inflation? If the ability to issue debt in your own currency is so valuable, why do countries give up sovereignty and join currency unions, such as the euro, or peg their currency to the dollar? What does MMT say about serial defaulters like Argentina? What about Germany’s hyperinflation that preceded the rise of Hitler? And while Kelton argues we should not worry about future entitlement obligations, what would MMT prescribe if those future payments ultimately drive up inflation? She fails to identify a single country that has successfully relied on deficits to maximize economic output.
MMT has become shorthand for unlimited government spending to solve every problem progressives can identify. Stephanie Kelton’s expansive vision of MMT’s possibilities cemented the conviction of many that our economy needs protection from the more liberal elements of Joe Biden’s party. It’s the type of thinking that denied Democrats a stronger electoral showing. Warren Mosler is rich enough to indulge such economic fantasies today, but I doubt 25 years ago he would have favored big government on such a scale.
In Lunch with the FT, journalist Brendan Greeley was disappointingly deferential. There’s little insightful in Kelton’s policy prescriptions. The type of profligate government spending she advocates has invariaby led to ruinous inflation elsewhere. If practised here, progressives would likely blame a Wall Street conspiracy for the economic destruction they had wrought. MMT isn’t a new idea, and isn’t a new source of money for liberals to spend. It should drift from the fringes of policy discussion to complete oblivion.
Stocks Are Still A Better Bet Than Bonds
In late April, a month after the low, we noted how stocks were cheap (see The Stock Market’s Heartless Optimism). The Equity Risk Premium (ERP, the difference between the earnings yield on the S&P500 and ten year treasury yields) is a useful barometer of relative value between the two major asset classes.
At the lows in March, the ERP on 2020 S&P50 earnings reached 5.0, and was 6.5 for 2021.
Now that the market has made a new all-time high, capping the briefest bear market in history, it’s no longer cheap although still attractive by historical standards. The 2020 ERP is 3.4 and 2021’s is 4.1.
The rally has mostly been characterized by multiple expansion. No big stock epitomizes this more than Apple (AAPL), which has almost tripled in value since the beginning of last year. It used to trade at a low double digit earnings multiple – it’s now at 30X 2021 Bloomberg consensus earnings. At $2TN in market cap, AAPL is over 7% of the S&P500.
As 2021 earnings forecasts were revised down through the worst of the pandemic, they still never dipped below last year’s. In other words, even at the depths of Covid despair, the earnings story remained that this was a one year hit that would see profits quickly rebound to prior levels.
Earnings forecasts for the following year are typically most optimistic in January. As time passes they are usually revised downward, probably as cautious management guidance gets reflected in analyst estimates. This makes it easier to subsequently beat expectations. But in recent weeks, 2021 earnings forecasts have been revised up modestly. The improved profits outlook has more than offset cautious guidance.
Given the impact on our lives and the relentless media reports of death, the stock market has provided an almost offensively optimistic perspective (see Is Being Bullish Socially Acceptable?).
The ERP shows stocks to be cheap because interest rates remain so low. Stocks are cheap relative to bonds. In the past we’ve illustrated this by calculating how much money invested in stocks would deliver the same ending value as $100 put into ten year treasury securities. The dividend yield on the S&P500 is around 1.8%, 1.2% above the ten year. Dividends grow while treasury coupon payments do not, and dividends are also taxed at a lower rate – at least, for now. The result is that it takes a lot less than $100 invested in stocks to match a ten year bond, assuming stocks don’t wind up lower in a decade.
The contrast is especially stark when applied to pipeline stocks. Enterprise Products Partners (EPD) maintained its payout through the 2014-16 energy downturn and, so far, through the Covid pandemic. Its dividend provides a 9.7% yield, a level that might suggest a high degree of investor concern about their prospects. However, bond investors see little to worry them. EPD recently issued ten year notes that currently yield 1.9%. A 30 year bond issued at the same time yields 3.3%.
Using the assumptions in the table, an investor about to commit $100 to EPD’s ten year debt could instead put just $8 into EPD common shares with the rest in cash (i.e. treasury bills), and achieve the same return. Even in a highly improbably EPD bankruptcy, a loss on the bonds of greater than 8% would still leave the equity as the less risky choice.
This math reflects the tyranny of low rates, and has been driving investors into stocks for years. Inflexible investment mandates that require holding bonds without regard to return are keeping rates low. The stocks in the American Energy Independence Index, of which EPD is a component, yield 8.8%. For those with sufficient flexibility, the stocks of these issuers are far more compelling than their bonds.
We are invested in EPD and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
Natural Gas Is November’s Winner
Citibank published some interesting research recently, making the case for higher natural gas prices in the months ahead. Oil production in the U.S. has fallen sharply as a result of Covid. Gasoline demand has recovered from its low point in April, but remains about 9% below normal.
Natural gas demand has shown much less impact, because it’s not used in transportation. The chart shows that it’s running the same as a year ago, although last week power consumption dipped. Power outages from Tropical Storm Isaias may have been partly to blame.
Citi’s forecast of higher natural gas relies on two factors: the drop in oil production has also reduced output of associated gas, which was most common in the Permian in west Texas. Oil prices drive the economics of drilling in that region. The resulting gas production was pressuring prices as well as causing more flaring (watch Stop Flaring).
The second factor relies on a Biden administration, which is looking the more likely outcome based on recent opinion polls. The thinking is that a Federal initiative to lower CO2 emissions will start with accelerating the phase-out of coal-burning power plants. This trend has been under way for several years, and represents the easiest steps an incoming President Biden could take to fulfill campaign pledges on clean energy.
Deferred natural gas futures pushed higher in recent weeks, reflecting higher prices a year out at the same time as opinion polls continue to show Biden in front.
Natural gas power plants typically release half the CO2 emissions of coal for equivalent energy production, and are also free of particulate matter and other pollution such as nitrogen oxides, sulfur dioxide, mercury and other hazardous substances that the local population inhales.
The Biden Plan for Climate Change targets “net-zero emissions no later than 2050.” However, the Biden-Sanders Unity Task Force says, “Democrats commit to eliminating carbon pollution from power plants by 2035.” A Biden administration would be under pressure from extreme liberals to adopt the more aggressive target, which Citi believes is likely.
Citi Research calculates that retiring the nation’s coal plants at a uniform rate would take approximately 10 Gigawatts (GW) of power offline annually. Assuming these plants are running at 48% capacity, as was the case last year, the country would need to add 4.8 GW of new natural gas power every year, requiring about 1 Billion Cubic Feet per Day (BCF/D).
Foreign demand is also increasing — both China and India have long term plans to use more natural gas. Nord Stream 2, which is being built to supply more Russian gas to Europe, continues to draw U.S. sanctions which may yet impede its ultimate completion.
Last year, the U.S. produced 92 BCF/D of natural gas, consuming 85 BCF/D domestically with the difference made up by exports (5BCF/D) and withdrawals from storage (1.4 BCF/D). Decommissioning coal plants could increase domestic demand by 1% or so annually.
So far, cheap natural gas has motivated the switch away from coal. Citi expects higher prices to reduce the economic advantage, but also believes this will stimulate increased production by 2022.
Although Trump’s election victory was welcomed by energy executives, their enthusiasm for a Republican administration freed their animal spirits in recent years, and investors have borne the cost. A pro-fossil fuel administration has been an excuse for many upstream and a few midstream companies to dump financial discipline and allocate capital with overly optimistic assumptions.
It may seem perverse, but a Biden victory could be good for pipeline investors, because it would impose a more cautious assessment of new projects. An industry held responsible for climate change by extremists in the president’s party would more likely be parsimonious in spending its cash.
New greenfield pipeline projects are already a non-starter because of relentless legal challenges, which many investors have welcomed (see Environmental Activists Raise Values on Existing Pipelines). Solar and wind projects are just as vulnerable to the same delaying tactics using the court system. New England is famously opposed to new pipelines (see An Expensive, Greenish Energy Strategy). But in 2017 an offshore wind project also fell victim to interminable delays, from property owners defending their ocean view (see After 16 Years, Hopes for Cape Cod Wind Farm Float Away).
Russell Gold recounted in Superpower: One Man’s Quest to Transform American Energy the challenges that defeated Michael Skelly in building high voltage transmission lines to send electricity from windy, unpopulated regions to cities.
New natural gas power plants retain a substantial cost advantage over renewables, even after many years of subsidies. It’s likely that a sharp increase in solar and wind farms, along with the associated power lines, will collide with the same NIMBY opposition through court challenges. Energy infrastructure that is already installed, such as natural gas pipelines, has an advantage.
Much can change over the 79 days until the election, but pipeline stocks have been outperforming the S&P500 since earnings were kicked off by Kinder Morgan last month (see Pipeline Earnings Provide A Boost). Dividend yields of 8-9% are drawing buyers who are looking beyond the opinion polls.
There’s no reason for equity investors in midstream energy infrastructure to be scared of a Biden presidency (listen to our recent podcast, Joe Biden and Energy). Bond investors see little of concern — Enterprise Products Partners (EPD) for example recently issued 30 year debt at 3.2%, while their equity offers a dividend yield over 9%. Compared with the past four years, equity returns are likely to be much better.
We are invested in the names mentioned above and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
Pipeline Earnings Provide A Boost
Investors often ask, what will it take to get pipeline stocks moving upwards? Attractive valuations and the prospect of higher cashflows are compelling, but when will investors start acting?
They may already being doing so. Kinder Morgan kicked off earnings after the close on July 23rd. Since then, results for the sector have generally come in as expected, with more positive surprises than negative. The encouraging free cash flow outlook remains intact (see Pipeline Cash Flows Will Still Double This Year). The most positive among the big companies was Williams Companies (WMB), whose earnings scarcely showed any impact of the pandemic (see Williams Has Covid Immunity). Their gathering and processing business held up better than volumes across the country, and WMB took another $100MM off their 2020 growth capex which further cheered investors. WMB was up 8% following the announcement.
The two big Canadians, Enbridge (ENB) and TC Energy (TRP) were both resilient. ENB even added $100MM to their growth capex plans – they’re probably the only company that could do so without seeing their stock sell off. TRP has one of the bigger capex budgets, mostly driven by the perennially delayed Keystone XL. Joe Biden has committed to withhold the required Federal approval of this cross-border project, reflecting a leftward shift in his platform. If he wins the election, Canadian oil producers will suffer but investors in TRP will likely benefit from higher free cash flow without the Keystone spending.
Cheniere Energy (CEI) reported $405MM of cargo cancellation revenues. Cheniere has always maintained that their 100% investment grade customer base and very long term contracts insulated the company from fluctuating volumes. Falling demand for shipments of Liquified Natural Gas (LNG) caused some weakness in CEI earlier in the quarter. The $405MM represents some tangible evidence of the security of the contracts. Typically, when a buyer cancels a contract CEI takes ownership of the LNG shipment and is free to find a new buyer.
Energy Transfer (ET) remains one of the cheapest big pipeline companies – their eye-popping 17% yield is in part because of CEO Kelcy Warren’s opportunistic ethical lapses (see Energy Transfer’s Weak Governance Costs Them). Questions remain around their elevated leverage, which is still above 5X. Some analysts would like to see them cut their distribution so as to delever faster. The company believes they can rely on growing EBITDA, although CFO Tom Long did say, “…the distributions are a topic when we discuss how to get the leverage down.” So that 17% yield isn’t secure.
Oneok (OKE) saw weaker than expected gathering and processing results, and they revised full year EBITA guidance to the low end of the range so they see continuing softness.
We thought Plains All American (PAGP), which is all crude oil, should have done better in their Supply and Logistics (S&L) segment. The dislocation in April was manifested by the negative price for front month of futures. This should have been a perfect environment to own storage assets in multiple locations and the pipes to connect them. Disappointingly, PAGP’s S&L segment adjusted EBITDA came in at only $3MM, and is running at $144MM for the first half of the year. During 1H19 they did $478MM. Management has done a good job at lowering analyst expectations for this business. Enterprise Products Partners’ (EPD) Marketing segment turned storae and contango opportunities into $185MM in 2Q20. PAGP should be aiming higher.
Overall, midstream energy infrastructure earnings were good, and with dividend yields still above 8% it is poised to move higher.
We are invested in the names mentioned above and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
Williams Has Covid Immunity
Pipeline company earnings continue to provide reassurance about their ability to grow cash flows (see Pipeline Cash Flows Will Still Double This Year). Yesterday’s earnings call with Williams Companies (WMB) was an example.
WMB’s 2Q adjusted EBITDA came in at $1,240MM, $48MM ahead of expectations. For the full year they are guiding conservatively to the low end of their prior range ($4.95BN-$5.25BN). 2020 growth capex was reduced by another $100MM to $1BN-$1.2BN. Like other pipeline companies, WMB’s continued trimming of growth capex is boosting their cash flow generation (see Pipeline Opponents Help Free Cash Flow).
Leverage has now come down to 4.31X Debt:EBITDA. Their $1.60 annual dividend still yields 7.5%, even after yesterday’s 8% rally in the stock.
WMB is among the best positioned pipeline companies – almost 100% natural gas. Its gas transmission business, which is 44% of EBITDA, is two thirds utilities and 90% investment grade. Gathering and processing, which is the rest of the company, has picked its customers well, growing 3.6% year-on-year even while Lower-48 production is roughly flat.
CEO Alan Armstrong noted what we’ve pointed out recently, that natural gas demand has remained strong and shows little impact from the pandemic (see Energy Demand After Covid-19). Armstrong also mentioned that canceled LNG shipments, the only area of weakness, appear to be moderating in July.
Armstrong spoke to the complimentary relationship gas-fired power generation has with solar and wind. Pairing always-available gas with intermittent renewables allows for increased use of both and lowers overall CO2 emissions. Since natural gas is crucial to any serious green initiative, WMB has a secure future (see Where America gets Its Power).
Transco, WMB’s extensive natural gas pipeline network that runs from Texas to NY, sits beneath many dense population centers. Given today’s uncertain regulatory process faced by new projects and successful opposition from environmental extremists (see Installed Pipelines Are Worth More), Armstrong feels that WMB’s extensive existing infrastructure gives them an advantage in expanding to meet growing demand. It’s much less disruptove to add on to an existing network than to embark on a new, greenfield project.
WMB’s business was neither helped nor hurt by Covid. In that respect it offers more visibility, if less excitement, than some of today’s high-fliers that are profiting from the new stay-at-home lifestyle. In effect, WMB is immune to Covid. It looks like a pretty cheap stock.
On a different topic, the owner of Jos A. Banks, Tailored Brands, recently filed for bankruptcy. I have followed Jos A. Banks with interest ever since 2008 when I saw Marc Cohodes, a short seller, explain why “Buy One Get Two Free” was not a sustainable business model for selling mens suits. I recounted this in The Hedge Fund Mirage. Cohodes had a tragically bad financial crisis for a short seller and for a time left Finance in disgust (see A Hedge Fund Manager Finds More to Like in Farming). On Jos A. Banks, Marc was early but ultimately right.
We are invested in WMB and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
The Biggest Pipeline Companies Are Doing Well
Last week Enbridge (ENB) and Enterprise Products (EPD), North America’s two biggest pipeline companies, were among those reporting earnings. Both beat expectations – ENB reported 2Q EBITDA of $3,312MM versus $3,155MM, helped by strong results in natural gas transmission. EPD came in at $1,961MM versus $1,877MM, boosted by strength in crude oil. Dividend yields of 7.7% (ENB) and 10.1% (EPD) look secure.
The earnings calls that accompany quarterly results often provide some interesting additions. The ENB call included several exchanges with analysts on renewables. For example, CEO Al Monaco noted, “…we know the supply profile is going to change globally for energy. It’s not going to be a quick transition by any stretch, but slowly renewables will be a bigger portion.” He continued, “U.S. offshore wind is certainly an attractive opportunity but… the supply chains are not as developed yet”
Bill Yardley, President of Gas Transmission & Midstream, added,“…on the ISO website… wind is 30 megawatts, natural gas is 10,200. You could quadruple the amount of wind as they’re projecting and it’s just–on the peak hours, it’s just not there.”
Although ENB expects renewables to gain market share, conventional fuels still get most of their spending on new projects. Al Monaco explained, “In terms of the asset mix today, I think when we repositioned the asset mix to almost 50/50, I’m going to call it, between natural gas and the liquids businesses, with a little bit in there for renewables, I think we’re happy with the mix there.”
Hydrogen as a potential renewable fuel has been drawing a lot of interest recently. For example, on Nextera’s (NEE) call, hydrogen appears 25 times in the transcript. But it’s still way off in the future. Rebecca Kujawa, CFO, noted that NEE is, “really excited about hydrogen, particularly in the 2030 and beyond time frame”
On the same topic, ENB’s Bill Yardley added, “Natural gas pipeline networks may be repurposed for hydrogen at some point in the future, if the economics work. To that end, It’s extremely expensive – you know, is it green hydrogen, is it blue hydrogen, how does it interact with the pipelines and the actual steel in the pipeline, and that takes a lot of engineering to look at. But you’re right – the network, and this is decades from now, would be well positioned if hydrogen transitioned from that shiny object that is potentially a solution to a reality.”
EPD’s CEO Jim Teague often adds some colorful phrases and humor to these calls. He referred to the prior quarter’s conference call as a “COVID call” and opened last week by saying, “…today, we are going to tell you our COVID story.”
Since EPD had beaten expectations during a tumultuous period in energy markets, Teague immediately addressed the issue: “We usually get the question of how much of our results are non-recurring, and it is the same question we got when Katrina blew through South Louisiana and literally knocked out every plant we had…Demand came back before indigenous supply and we made more money with our West to East pipelines than if those plants had been running. So it was non-recurring.
“We got that question during Hurricane Ike in 2008… got the question in Hurricane Harvey in 2017.” Teague continued,” Events like what we are going through now, and the opportunities they present may be labeled as non-recurring, but our performance and our results are recurring regardless of the environment.” In other words, the diversity and naturally offsetting risks among business lines create the opportunity for recurring upside surprise.
Crude oil dominates sentiment around pipelines, although natural gas is more important. Little attention is paid to the non-energy side of the business, such as plastics. Teague reminded listeners that,“…the United States, especially in ethylene, has quickly moved into being the world’s incremental supplier.” He added, “In June, we loaded a record size ethylene cargo of 44 million pounds.”
Growth capex is also falling as both companies are maintaining strict return criteria. Teague said, “For 2021 and 2022, we currently anticipate growth capital investments to be approximately $2.3 billion and $1 billion respectively. This is an aggregate $700 million reduction from guidance we provided for 2021 and 2022, at the end of the first quarter.” Last year EPD spent $4BN. Their Free Cash Flow in 2022 is on track to have doubled in only three years.
Both companies can issue ten year debt “with a two handle”, reflecting the confidence of bond investors in their balance sheets and showing a juxtaposition with their dividend yields.
Earnings continue to support our expectation of strong cash generation (see Pipeline Cash Flows Will Still Double This Year). Listening to conference calls like these provides further comfort around the outlook.
We are invested in ENB, EPD, and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
Lower Spending Cheers Pipeline Investors
In February, following our criticism of Kinder Morgan’s (KMI) return on invested capital (see Kinder Morgan’s Slick Numeracy) the company, to their credit, reached out to us so as to better present their perspective. Our point was that capital allocation decisions in recent years had not always been accretive to equity. We offered the company an opportunity to write a rebuttal which we promised to publish, unedited, but they declined. So we summarized their response (see Kinder Morgan Responds to our Recent Criticism).
Not long after, Covid dominated the news, and historic returns on invested capital took a backseat to gauging current demand destruction. KMI’s stock sank from $21 to under $10, before recovering roughly halfway to $14.
KMI kicked off earnings reports for the sector last week. We were most interested in their outlook, but also in their planned growth capex. Industry-wide spending reductions are driving improved profitability (see Pipeline Cash Flows Will Still Double This Year).
KMI announced a $1BN goodwill writedown on natural gas gathering and processing assets previously acquired. Although a non-cash expense, this is an example of capital deployed whose cash generation will no longer meet its target. KMI will blame Covid, but nonetheless it’s a loss for shareholders.
The company confirmed guidance of $1.7BN in “expansion opportunities” (we winced) for 2020. This is well below their prior range of $2-3BN annually over the next decade, as initially communicated in April during the depths of lost production. Several questions followed on the earnings call – in response to Shneur Gershuni of UBS, CEO Steve Kean allowed that future capex, “looks like it hangs around the level we’re seeing in 2020, maybe a little less.”
This cheered us, and later JPMorgan’s Jeremy Tonet asked, “…is there a scenario where 2021, or maybe in 2022, where growth CapEx could be as low as $1 billion?” We were left positively giddy when Steve Kean replied, “We’re close, yes. We’re close.”
When it comes to pipeline company growth capex plans, they share the qualities of an overly vigorous golf swing – less is more.
KMI’s adjusted EBITDA came in at $1,568MM versus expectations of $1,634MM. They also lowered full year DCF to 11% below budget (was previously 10% below). They still plan to increase their dividend to $1.25 annually, which would yield over 8.5% at the current stock price. They expect to reach 4.5X Debt/EBITDA although conceded 4.7X is their likely year-end level. They also pushed back the date at which they expect to be a corporate taxpayer to 2026.
Meanwhile, domestic production is recovering along with demand. In recent weeks, oil production has risen from 9.7 Million Barrels per Day (MMB/D) to 10.9 MMB/D, and the industry now expects it to settle in around 11 MMB/D. That’s still well below the pre-Covid level, which was on track to hit 13 MMB/D by year’s end. But it’s improving. “It’s a slow, slow recovery, but it’s happening,” said Alexandre Ramos-Peon, a senior analyst at Rystad Energy, a consultancy.
Natural gas demand of 85.5 Billion Cubic Feet per Day (BCF/D) remains close to a year ago of 89.4 BCF/D, exhibiting very little response to Covid. LNG exports of 3.7BCF/D are down by 2.4 BCF/D, representing more than half the drop as global LNG demand has softened somewhat. Overall, the market hasn’t registered much impact.
Pipeline stocks such as KMI have dividend yields that reflect considerable market skepticism regarding their longevity. Bond investors harbor few doubts, as we noted recently in comparing Enterprise Products Partners 30 year debt yields of around 3% with the almost 10% dividend yield (see Pipelines Are Becoming Less Risky). KMI just announced a 2050 maturity with a 3.25% coupon. The chasm between dividends and bond yields in this sector reflect rigid investor segmentation, and a misallocation of capital by fixed income buyers who would greatly benefit from the flexibility to incorporate some equity risk.
Earnings reports from other big pipeline companies over the next few weeks should provide confirmation of growing free cash flow and secure dividends.
We are invested in EPD, KMI and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
Pipelines Are Becoming Less Risky
Before the Shale Revolution, midstream energy infrastructure was a boringly stable sector. MLPs, which predominated versus corporations back then, paid out most of the cash they generated and grew distributions through price escalators and improved operating efficiencies. Volatility was low, and attractive yields drew income-seeking investors. This happy marriage started to fall apart in 2015, when the industry embraced the same growth ethos that drove their upstream customers. Leverage and volatility rose, causing distribution cuts and the older, wealthy K-1 tolerant American investor started to leave (see AMLP’s Shrinking Investor Base).
In conversations with investors, the subject of volatility often comes up. Yields are attractive – the broad-based American Energy Independence Index, AEITR yields 9.3% on a trailing basis. Few cuts in payouts are likely as companies report 2Q earnings. Kinder Morgan (KMI) maintained their dividend in Wednesday’s release. Some had been questioning whether Oneok (OKE) would maintain their dividend, but they reaffirmed it on Thursday, yielding 13.4%. Legal uncertainty remains around whether the Dakota Access Pipeline (DAPL) has a secure future (listen to Judicial Over-Reach on the Dakota Access Pipeline). Phillips 66 Partners, LP (PSXP) is most exposed, but they’re only 0.6% of the AEITR. Although Energy Transfer built DAPL and retains 36% ownership, it’s only 3.5% of their EBITDA.
In summary, payment of today’s attractively high payouts is likely to continue. Investors are trying to assess whether they’ll need to endure further downside volatility while clipping coupons.
Relative to the overall market, the movements of today’s pipeline sector are more pronounced but still well short of the 2015 collapse, when energy sector weakness didn’t spill over into the S&P500. Early this year saw the biggest fall in AEITR’s history, but the panic over Covid drove the S&P500 down in the first quarter too, as indiscriminate selling was widespread. Although pipelines have rebounded strongly since then, the AEITR remains down 27% for the year – 10% ahead of the MLP-heavy Alerian Index, but still well short of matching the market, which is in positive territory.
There are three reasons to think that more stability lies ahead for the sector. First, spending on new projects peaked in 2018, and the pandemic has caused every company to further reassess plans for 2020. The result is that pipelines will generate twice as much cash as they did last year (see Pipeline Cash Flows Will Still Double This Year).
Second, closed end funds, whose selling in March exacerbated an already extremely weak sector, have lost much of their ability to repeat this performance. This is because heavy losses destroyed much of their asset base, a development welcomed by all except those unfortunate enough to have assumed the fund managers practiced any responsible oversight of their leverage (see The Virus Infecting MLPs).
Third and perhaps most importantly, pipeline companies are reducing leverage. These slides from recent investor presentations by Enterprise Products, Kinder Morgan and Williams Companies are reflective of what’s happening across the industry. Stronger balance sheets will reassure rating agencies and investors that sharply rising free cash flow is sustainable.
These are all reasons to believe that tomorrow’s pipeline industry will return to the lower volatility and higher returns of 5-10 years ago.
We are invested in EPD, ET, KMI, WMB and all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
Covid By The Numbers
The recent news on Covid-19 has been mostly bad. Infections are increasing sharply in sunbelt states, where Florida now holds the record for two worst days’ new infections – 15,300 and 13,965, both reached last week. Reopening plans are being halted. Even the Republican convention scheduled for late August, which was moved from Charlotte, NC to Jacksonville, FL (i.e. from a Democrat governor to a Republican one), has been scaling back its planned attendance.
We’ve aimed to be apolitical in covering what is the biggest story concerning investors nowadays (see Taking The Politics Out Of Covid-19). Writing about this is a fraught subject – you don’t want to get Covid-19, and there have been over 140,000 deaths each one of which is a tragic loss. It continues to be a traumatic time for the country. My mother is high risk, in assisted living, and our interactions with her are constrained in both frequency and form.
Nonetheless, we focus on the data, which we interpret as more optimistic than the media coverage for the overall population. Some readers have criticized us for this. Equity markets clearly have a more sanguine view (see Is Being Bullish Socially Acceptable?), and investors may be wrong or they may collectively also be interpreting the data as more positive. We think it’s worth trying to understand the implied relative optimism, as it contrasts so strongly with how many of us feel.
With that preamble, let me introduce a fascinating table that Kyle Lamb has recently posted on Twitter analyzing Covid-19 fatalities. Some effort is required to fully appreciate the depth of information it contains – we’ll explain:
The Center for Disease Control (CDC) publishes a Provisional Death Count which tracks “deaths involving Covid-19”. CDC data relies on death certificates being processed, so lags by several weeks the data published by the Covid Tracking Project (CTP), which is what most media outlets use. Although both produce weekly data, the CDC updates prior weeks for a couple of months, as they receive new information.
For example, reading off the table for the week ending April 4, CTP shows 6,962. The CDC data shows 9,909, a figure they’ve been revising up every week. The first time they reported a figure for April 4 was on April 11, and it was 2,602. If you sum all the colored cells horizontally, you get the fatality total for the week in the “When Died” column.
If you sum the colored cells vertically, you get what the CDC revisions to prior weeks totaled.
Both have revised their websites to higher figures since the table was produced.
What the table does is break down the CDC fatalities for any given week into multiple weekly buckets to show when they were reported. So the red cells show the CDC’s initial estimate of fatalities for that week. Moving to the right, the orange cells show the number of additional fatalities added to that week’s total a week later.
So what’s the point? Although the CDC’s initial weekly estimate is always revised up, after eight weeks they have most of the data. Within the first two weeks, they typically have 50-60% of the ultimate total for that week.
On April 18, the CDC reported 4,811 deaths for the prior week, a figure that eventually rose to 16,014. The most recent week on the table, ending July 18, shows 272 for the prior week (more recently revised up to 1,099 on the CDC website, which could mean faster reporting or increased fatalities). As the CDC’s initial weekly estimates are falling, it’s reasonable to assume that the ultimate figures will also fall. Clearly sunbelt states are seeing increases, but today’s infected patients are faring much better. They’re younger and are benefitting from improved treatments. Nursing homes have learned to better protect their highly vulnerable residents. CTP fatalities remain well under half the levels of April, when New York was the epicenter.
Stocks continue to trend higher. You should still wear a mask, practice social distancing and wash your hands frequently, as we do. But we’re getting through this.