Archive for category: MLPs

Investing in midstream energy infrastructure today means pipelines, storage, gathering and processing and all the physical networks that sit between oil and gas wells and their customers. It doesn’t have to be limited to servicing non-coal fossil fuels. We research and think about other sources of energy including nuclear, renewables and coal.  We prefer the more visible cashflows that come with handling and transporting energy over the cyclicality and capital intensity of production and generation. It’s why we have avoided upstream oil and gas, coal mining, and power generation companies.

Mining and burning coal releases many pollutants including nitrous oxide, sulfur dioxide, particulate matter and other pollutants. It is in long-term decline in North America.  Furthermore, transportation is by rail and ship, which have lower barriers to entry than pipelines.

Public opposition to nuclear has added uncertainty and harmed economics, which makes investing unattractive.

However, renewables offer the opportunity for both long haul transmission lines and large scale storage. These are two areas with the potential for visible, persistent cashflows, although today there are few opportunities for scale and pure plays. Renewable generation is largely owned by utilities within portfolios that include coal, natural gas, and nuclear assets.

An exception is NextEra Energy (NEE), the world’s biggest producer of wind and solar energy. They’re the largest component of the SPDR Utilities ETF (XLU). On a list of countries ranked by wind power generation, they would be 8^th. Just as the Shale Revolution has created ample opportunities to invest capital for growth, so has the burgeoning renewables business in the U.S., albeit with a wholly different response from investors.

Although energy investors have revolted against endless investments in more production and additional pipelines, NEE investors cheer the company’s stepped up commitment to renewables. Over the past year, their stock has returned 24%,  8% ahead of the S&P500 and 16% ahead of XLU. From 2015-18 NEE’s capex rose from $3.9BN to $6BN, a pace they expect to maintain over the next four years. They’re planning the world’s biggest battery center by a factor of 4X, in central Florida, to store intermittent renewable energy for later use when it’s not sunny or windy.

Much of this investment will be in new wind and solar generation, a sector NEE expects to enjoy 15% annual growth through 2030. This growth will be driven by declining prices for produced power. NEE expects improving technology to bring the cost per Megawatt Hour for wind and solar below all other sources.

CEO Jim Robo recently led an investor day during which his team enthused about the being a low-cost renewables company delivering the benefits of clean energy to customers and investors.

But here’s the catch. The company is plowing capital into assets that will depreciate, because continued efficiencies will lower the price of produced power. It’s analogous to holding a huge inventory of microchips when Moore’s Law dictates that the cost of computing power falls by 50% every 18 months; or of stocking millions of iphones, when the next version will drive down the price of the old ones.

Rapid advances in technology cause deflation in assets. While Intel and Apple have shown that it’s highly profitable to manufacture products with continuous improvement, NEE is on the other side of this trade.

It means that every windmill they install and every battery facility they build is worth less than it cost from the moment it begins operation. The falling cost of renewable energy, which is driving their pursuit of growth, threatens to erode the pricing power of the assets they’re developing.

Correctly assessing the cash flow generating capability of a new solar facility must be hard. NEE can depreciate their property, plant and equipment (PP&E) based on the physical useful life of what they’ve bought, but the impact on cashflows from future pricing pressure is less clear. As their installed asset base ages, they’ll become less competitive, unless they constantly reinvest to upgrade their depreciating equipment. They face a constant uphill struggle to maintain competitive, cost-effective assets.  Eventually, they’ll reach a cash flow cliff as their contracts roll off.

In 2018, NEE’s depreciation of its renewables-heavy PP&E jumped, and is now higher than peers Duke Energy (DUK) and Dominion Energy (D), the 2^nd and 3^rd largest components of XLU respectively. At $3.9BN, it was two thirds of their growth capex. In other words, two thirds of their capex is spent to preserve the value of their PP&E. Assuming straight line depreciation, NEE expects its existing asset base to have a useful life of just over 18 years, which contrasts with the 35X earnings multiple assigned its stock by the market. Free Cash Flow has been declining as a percentage of net income, and will shift negative this year.

NEE is a company that’s investing heavily in the future, but will always be racing against advances in renewable technology. A purchase delayed will provide cheaper power, later. Advances in renewables may one day cause an impairment charge on old assets struggling to compete. A 10% write-down in PP&E would wipe out a year’s profits.

The irony is that pipelines regularly raise prices, and the sector has been punished by investors for spending on new infrastructure to transport growing oil and gas output. Disruptive pipeline startups are rare, because expanding an existing pipeline brings network effects and is cheaper than building new. Moreover, FERC’s regulatory framework  recognizes the oligopolistic role pipelines play and is designed to limit egregious pricing.

By contrast, NEE is being rewarded for investing heavily in assets whose pricing power diminishes. It’s true their customers are locked in via long term power purchase agreements. One of these is being challenged by bankrupt PG&E in California, although NEE is confident it will be upheld. But they still face the risk of lower-priced competition in the future, and no-one knows if regulators will allow them to charge customers rates above what new power assets would dictate indefinitely. Their potential competitors include new entrants unburdened by legacy, inefficient infrastructure. Even their customers can turn into energy providers by adding rooftop solar panels. The technology around renewables and battery storage continues to improve, creating the possibility of further disruption by new entrants.

We don’t own NEE. By all accounts they are a well-run company. Their progress will provide a useful guide to the growth of renewables in the U.S. and their ultimate profitability.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Nothing exemplifies America’s low natural gas prices more than its flaring where takeaway infrastructure is inadequate. In the Permian basin in West Texas and New Mexico, from where most of the growth in crude production originates, associated natural gas is more often a disposal problem, like wastewater. Oil production has grown faster than expected, leaving gathering and processing systems struggling to keep up. Natural gas is hard to handle. Transportation by truck isn’t common because it has to be compressed, requiring specialized equipment. Mexican utility demand has grown more slowly than planned, and absent pipelines for transportation elsewhere in the U.S., the only remaining option is flaring.

A few years ago North Dakota faced a similar problem. Nighttime satellite photos revealed what looked like a new, brightly lit city in an uninhabited part of the country. Although regulators typically allow flaring for limited periods of six months or so, volumes of wasted gas continue to grow. By one estimate, the natural gas currently being flared in the Permian could power every home in Texas. The Texas Railroad Commission (RRC) regulates flaring permits. Oil drillers routinely request and receive permission for flaring where they can argue that oil can be profitably produced but there’s no take-away infrastructure for natural gas.

In theory, flaring requests can be challenged although they never are. Last week the RRC heard an application which raised an interesting question whose resolution could have a profound impact on such permits in the future. Exco Operating Company, LP sought a flaring permit on the basis of unavailable pipeline infrastructure. Unusually, it was protested by Williams Companies (WMB) who owns a nearby gathering and processing network. You can watch a video recording of the hearing here. Go to Item 9.

It turned out that a gathering pipeline was available to transport the associated natural gas, but Exco felt the economic terms were unfair. As the owner of the only available pipeline, Exco argued that WMB could charge an unfairly high price. Natural gas pricing at the Waha hub in Midland, TX has often been negative this year, meaning gas producers have to pay to offload their output. So it’s likely Exco was balking at pricing that reflected the paucity of options.

This led to an interesting dialogue between the RRC commissioners and representatives of Exco and WMB. The RRC has traditionally been charged with minimizing the waste of oil and gas. Natural gas flaring has been allowed because it’s necessary to access the crude oil. But Exco’s argument was one of economics. Implicit in their flaring request was that disposing of the natural gas would cost them more than its value.

As one commissioner noted, if flaring permits were based on economic hardship, there would be no need to have an approval process because companies would simply flare when that provided a better return than accessing a pipeline. And yet, the RRC is charged with regulating flaring, which means there must be some other, non-financial framework they’re intended to follow.

It was fascinating to watch both lawyers and the commissioners spar over this issue. WMB noted that the pipeline had been built at a cost of $1.5BN in order to gather gas from wells such as Exco’s, and said that Exco could have built their own takeaway pipeline early in the process but chose not to.

The RRC recognized the fundamental question raised by WMB’s challenge to Exco flaring application. It seems that however it’s resolved, it will set a precedent for future applications. Exco’s view would negate the need for the RRC to regulate flaring, since the decision would be a financial one for the company. WMB’s view would require drillers to access a gathering system where available even if pricing was unattractive.

The RRC decided to pass on the case at its first hearing, leaving it currently unresolved. When they meet to reconsider, the result could be far-reaching. If the RRC requires drillers to use available gathering and processing networks regardless of economics, as WMB wants, that would be good for pipeline investors.

Join us on Thursday, July 11th at 1pm EST for a webinar. We’ll discuss the pipeline sector’s growing Free Cash Flow. To register, please click here.

We are invested in WMB.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Last year the U.S. set a new world record for annual increase in production of oil and gas by any country in history. The recently-released BP Statistical Review of World Energy 2019 highlights these and many other useful facts.

Total U.S. energy consumption rose by 3.5% last year, the fastest in 30 years and a surprising jump following a decade of no growth. Growth in population and GDP have normally been offset by lower energy intensity and improving efficiency. But periods of extreme weather (both excessive heat and cold) boosted energy demand, as well increased use of ethane for America’s resurgent petrochemicals industry.

The U.S. was one fifth of the 2018 increase in global energy consumption, with China and India together representing half. Climate change and CO2 emissions figured prominently in the report. Developed countries desire lower emissions and emerging countries higher living standards. China consumes 42% more energy than the U.S., a gap that will grow in the decades ahead. The resolution of these conflicting goals dominates the outcome.

So it’s worth noting that the Asia-Pacific region energy consumption is more than double North America’s, and half of this comes from coal. The difference in coal volumes is by a factor of 8X. China alone consumes 6X as much coal as the U.S. But to illustrate unmet energy demand, China and India’s per capita consumption of crude oil is only 10% that of the U.S.

Until we confront these twin issues, little else that’s done to reduce emissions will have much impact.

Global carbon emissions grew by 600 million tons, or around 2%, the fastest for many years. This is the equivalent of increasing the global passenger car fleet by a third. Last week, India’s Adani Mining won Australian regulatory approval to begin developing one of the world’s largest untapped coalmines. Its critics contend that this project alone will eventually add 700 million tons of CO2 emissions, exceeding last year’s global increase from all sources. This is where India’s desire for more energy to raise living standards manifests itself. New York’s environmental extremists opposing a new natural gas pipeline might consider where the real problem lies.

Increased use of renewables alone will not solve the issues of climate change. BP notes that simply maintaining carbon emissions from the power sector at 2015 levels would have required growth in renewables generation at more than double the actual rate. The additional output is equal to all of the U.S. and China’s 2018 energy output from renewables.

Natural gas provided 43% of the additional power the world consumed, more than twice that provided by renewables. For all the excitement about increasing use of solar and wind, their share rose by 1.4%. 84.7% of the world’s energy came from fossil fuels in 2018, versus 85.1% in 2017. As Bill Gates and others have pointed out, R&D should be directed towards making the 85% less carbon intensive, rather than trying to replace what obviously works.

Netpower is developing the ability to generate electricity from natural gas with no emissions, which would represent a significant breakthrough if successful.

It’s still possible to find writers warning of a production collapse because of shale’s chronic unprofitability.  An article on Seeking Alpha (see Here’s Why Oil Stocks Are Priced For Armageddon) or Bethany Mclean’s Saudi America: The Truth About Fracking and How It’s Changing the World both reflect a simplistic view. Exxon Mobil (XOM), now the biggest driller in the Permian, clearly finds it profitable. Anadarko had two suitors for its Permian assets. Volumes keep growing, in defiance of some writers’ claims to better understand the economics.

BP’s report showed that the 2.2 Million Barrels per Day (MMB/D) of increased global crude oil production came from the U.S., a point echoed in Plains All American’s (PAA) Investor Day.

The path to lower global emissions requires far more use of nuclear power, far less coal use in China and India, and more R&D into using existing energy sources more efficiently. Otherwise, investments in seawalls and flood mitigation will be a safer bet.

We are invested in PAA, via Plains GP Holdings.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Wednesday’s report on crude oil stocks from the Energy Information Administration (EIA) showed a sharp jump in storage of 1 million barrels per day (MMB/D). Given the already fragile mood around tariffs slowing GDP growth, crude oil prices predictably slumped.

Interestingly though, over the past year the “Adjustment”, or fudge factor which is used to make the numbers add up, has grown substantially.

In simple terms, the EIA counts production, exports, imports, change in storage and refinery usage. This should pick up every barrel of oil moving through the U.S. It must frustrate the EIA’s number crunchers that the figures never foot, so they use a balancing item which used to be called “Unaccounted for Crude Oil”, nowadays simply the Adjustment. Since June 2018, the Adjustment has almost tripled.

Over the past year, crude oil used by U.S. refineries has been stable. Because much of America’s increased production is light crude from the Permian ill-suited to domestic refineries, imports have also remained unchanged. Higher exports have absorbed most of the increase in output.

The Adjustment exists solely because one of the other figures is wrong. So we’re refining more, exporting more, importing less, storing less or producing more than reported. Of these five different items, some should be easier to measure than others. The refinery figure seems unlikely to be far wrong; refineries must know what they’re using and there are 135 refineries in the U.S. from which to gather information.

Similarly, imports must surely be correct since the government licenses imports, and counting exports would also seem reasonably straightforward – the number of points of exports (cross-border pipelines and crude-loading export facilities) are known and not that numerous.

However, in reviewing the EIA’s methodology for calculating exports, they rely heavily on data from the U.S. Customs Border Protection (CBP) as well as figures from Statistics Canada (since exports to Canada don’t require a U.S. export license). The EIA runs the data through estimation models that they believe improve its accuracy. In some cases they’re using monthly data, even though their report is weekly.

There are many types of petroleum product beyond crude oil, including finished motor gasoline, kerosene, distillate and residual fuel oil among others. And the granting of an export license need not coincide with the physical shipment of the product. So it’s a more complex task than you might suppose.

Storage would also seem straightforward. Storage terminals are hard to miss. So the 967 thousand barrels per day (MB/D) build in storage ought to be reliable. Since the prior week saw a 41 MB/D decrease in storage, crude traders inferred softening demand.

But storage has its own complexity, since crude oil sitting on a tanker awaiting unloading is, in effect, floating storage. A possibility suggested by one sell-side firm is that floating storage was drawn down sharply. This presumes that several million barrels of crude was in tankers bobbing within U.S. territorial waters, already counted as imported but not yet unloaded. If true, this would mean the apparent jump in onshore storage was offset by a drawdown in floating storage, making the report far less bearish.

While this could explain the sudden, one-time shift in the storage figure, the Adjustment was the same last week, which undercuts the logic behind this explanation.

This brings us back to production, currently estimated at 12.4 MMB/D. Of the line items in the EIA’s report, it seems to us that this one is most plausibly the source of the growing Adjustment. There are around a million wells in the U.S. producing crude oil, from some decades old dribbling out a few barrels a day to new Permian wells producing 10 MB/D or more. We think it’s likely that the EIA is somehow undercounting crude oil output.

Flaring of associated natural gas in the Permian recently hit 661 million cubic feet per day (MMCF/D), up sharply from the previous high late last year of 450 MMCF/D. This reflects growing crude oil production. The continued shortage of take away infrastructure in the region to handle the natural gas that is extracted with the crude oil is why there’s more flaring.

Nobody really knows why the EIA’s weekly report includes an error term that is growing embarrassingly large. Robert Merriam, director of the office of petroleum and biofuels statistics at the EIA, admitted, “There’s something more systematic going on that our surveys aren’t capturing. We have some theories on what that may be and we’re trying to look into it.”

Undercounting crude oil production seems the most likely explanation. If so, this would reinforce a couple of important themes:

1) The U.S. continues to gain market share in world energy markets

2) Growing volumes even with moderate pricing defy those who argue that much of our shale activity is unprofitable

Oil and gas production continue to surprise to the upside, which can only be good for midstream energy infrastructure.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

A common concern of both existing and potential investors in energy infrastructure is the relatively high volatility of recent years. Many recall the “toll-model” of pipelines that was the basis of their appeal prior to 2014. As we have often written, the Shale Revolution broke the MLP model, as companies with very high payout ratios and hitherto minimal growth projects set about adding infrastructure. Oil in North Dakota, natural gas in Pennsylvania and increasing volumes of crude in west Texas required new investments (see It’s the Distributions, Stupid). The income-seeking investors originally attracted by high yields wound up in growth businesses that prioritized reducing leverage and funding projects over maintaining distributions.

Our theory is that this one-time alienation of the core investor base was highly disruptive and led to a period of heightened volatility. The shift in MLP business model from income generating to growth coincided with a sharp downturn in the energy sector. Investors worried about the profitability of upstream exploration and production companies showed similar concern over midstream. Even though EBITDA grew and leverage fell for pipeline stocks during this period, the sector moved with the energy sector.

There are signs that this period of heightened volatility is coming to a close. When energy markets bottomed in early 2016, the average daily percentage move of the Alerian MLP index reached almost 2.0X that of the S&P Energy Sector ETF (XLE). In late 2017 the ratio was briefly even higher. Since then, this relationship has improved dramatically in favor of these toll-like business models, falling by more than half and approaching the range that prevailed 7+ years ago.

This shift is even more dramatic than it seems, because the Alerian MLP index has been steadily losing components, rendering it less diversified and therefore more prone to sharp moves than it would otherwise be. Investors continue to exit mutual funds and ETFs tied to MLPs, as shown by the steady drop in shares outstanding for the Alerian MLP ETF.

Nonetheless, relative performance for the sector more broadly defined to include corporations has held up very well. The American Energy Independence Index (80% corporations and 20% MLPs, more reflective of the sector’s market cap of 2/3rds corporations) has retained its solid lead over the S&P500 this year, and is substantially ahead of XLE, especially following last week’s market weakness.

A plausible explanation is that, although retail investors are shunning MLP-only funds, institutional buyers are beginning to commit capital to pipeline corporations. Converting from MLPs to corporations was driven by a desire for a broader, more stable investor base. Although there are fewer MLPs remaining, they include conservatively run companies such as Enterprise Products Partners (EPD) and Magellan Midstream (MMP). There are some good MLPs to own.  However, some investors are starting to conclude that MLPs are too small a subset to command a sector allocation, and they’re more appropriate within a diversified portfolio that includes corporations.

The relative volatility of midstream infrastructure is reverting back to the lower levels that prevailed before the Shale Revolution triggered the need for large infrastructure investments. Moreover, free cash flow is set to jump over the next three years (see The Coming Pipeline Cash Gusher). This will continue to attract generalist investors interested in attractively valued stocks with declining volatility.

The pipeline sector is showing good momentum to continue its outperformance, driven by institutional buyers gradually replacing the retail holders of narrow, MLP-only funds.

We are invested in EPD and MMP. We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).