Investors Rotate Into Energy

November is on track to be the second best month in the history of the American Energy Independence Index (AEITR)Through yesterday, the index is up 27% for the month. April’s 39% bounce off the March lows is the biggest, but with the index having doubled in value since then, November is on track to be the biggest points move ever. It’s eclipsed the June high, and has recovered to 12% YTD (the S&P500 is +16% YTD).  

Jim Cramer has even offered some reasons to buy – describing President-elect Joe Biden as “the counterintuitive savior of the oil industry”. He’s echoing a point we’ve made – that Democrat policies favor higher energy prices (see Why Exxon Mobil Investors Might Like Biden). Combined with a more cautious attitude towards growth projects, an era of growing free cash flow is at hand for midstream energy infrastructure – a trend that’s remained in place all year and is returning cash to shareholders (see Pipeline Buybacks Are Coming). 

Although energy is enjoying a strong month, fund flows are not yet following which suggests a healthy skepticism remains. Investors in this sector have seen too many false dawns, and remain cautious. Nonetheless, with recently announced buybacks being big enough to counter the typical outflows of the past few months, it won’t take much of a shift by investors to cause net buying.  

The vaccine news triggered the rally, but the fundamental outlook had been improving for months before that. Other than Energy Transfer (ET), all paid dividends as expected following 3Q earnings. The components of the AEITR now yield just under 8% on a market-cap weighted basis – almost 4X the S&P500. 

The energy sector is the biggest beneficiary of the huge shift under way from technology to value (see The Big Rotation Begins). Since the ratio of the QQQ to the Russell 2000 (IWM) crossed its 200-day moving average on November 9th, when Pfizer’s vaccine news broke, it has moved decisively lower. 

The North American pipeline sector has a float-adjusted market cap of around $375BN, less than a fifth of tech giant Apple (AAPL). Exxon Mobil is $175BN. Energy has sunk to below 3% of the S&P500. 

The strong performance of technology stocks in recent years means that if just a small percentage of investors switch from tech to energy, it’s likely to move higher given their relative size. 

Meanwhile, we can look forward to incoming Climate Change Czar John Kerry overlooking his own outsized carbon footprint while lecturing the rest of us about ours.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.



The Hidden Cost of Renewables

Renewables receive a disproportionate share of media coverage given their still small size. In 2019, less than 9% of America’s power came from solar and windFossil fuels (mainly coal and natural gas) are over 62%. Moreover, electric power is only 37% of our total energy use. Renewables receive outsized attention because of the hope they will lead to lower emissions. A look at recent daily data on U.S. power generation illustrates the challenges we’ll face in relying on intermittent, low-density sources of energy.  

California is a leader in moving away from fossil fuels. We should hope the rest of America doesn’t seek to emulate them, because Californians pay the most for the least (see California Dreamin’ of Reliable Power). 

The first four charts draw on hourly electricity generation across the lower-48. Solar and wind are both intermittent – solar is fairly predictable,  and wind less so. The challenge for grid operators is matching demand with supply.  

Over a recent seven day period, solar and wind provided 15% of our electricity, but the range was between 8% and 21%. Because their share is still small, this variability is easily managed by dialing other power sources up or down as needed. Natural gas combined cycle (NGCC) plants have the advantage of being easily recalibrated to accommodate fluctuations in nature’s power output. Their flexibility enables increased use of renewables – a benefit Californians are denied because of a purist dogma that has seen them phase out even natural gas power plants. 

In combination, solar, wind and natural gas provided almost half our electricity over a recent seven-day period. What’s especially interesting is that natural gas output is strongly negatively correlated with the intermittent sources. This highlights the symbiotic relationship between the two.  

Power demand isn’t constant – it’s higher during the day and peaks around dinner time. So we need variable sources of power. For example, if we used nuclear power exclusively, its constant output would require either storage or supplementary power to match demand.   

Cost estimates of intermittent power sources need to include either complimentary natural gas power or battery back-up. Breathless media coverage of the topic rarely considers the fully-loaded costs.  

The chart below is from a paper published by the University of North Carolina which compared the cost of electricity from an NGCC with different combinations of renewables and back-up to achieve the same output for the 85% of the time such plants typically run. Solar and wind generally product at about 25% of capacity.  

None of the alternatives are cheaper than an NGCC, although solar with NGCC back-up is the cheapest of the three alternatives considered.  

In recent years natural gas has been the biggest contributor to falling U.S. emissions, and is enabling increased use of renewables. Continuing this success is our best path to combating climate change.   

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Energy’s Momentum Continues

Last week’s news from Pfizer triggered some big sector moves, as investors sold technology stocks in favor of value like energy and financials (see The Big Rotation Begins). Pfizer CEO Albert Bourla didn’t overstate the case when he said, “It is a great day for humanity when you realize your vaccine has 90% effectiveness. That’s overwhelming,” 

Moderna followed up with their own vaccine announcement this week, topping Pfizer with 94.5% efficacy. Even though this news was telegraphed by Anthony Fauci days earlier, the switch into value stocks has continued.  

On the day of Pfizer’s announcement, the American Energy Independence Index (AEITR) solidly crossed its 200day moving average. It has continued to move sharply higher since then, outpacing the S&P500 by 10%. The prospect of a return to normalcy within six months or so has lifted sectors that Covid has hurt, such as energy.  

Yesterday showed the energy demand for pipeline stocks, as the sector opened down on the day but traded up from then on, increasing its recent outperformance against the S&P500.  

For the past six months, investors have wrestled with the conundrum of the Covid pandemic and rising equity markets. During the spring, the news seemed so relentlessly bad that holding a constructive view on stocks seemed insensitive (see The Stock Market’s Heartless Optimism).  

Superlatives were inadequate for the many record statistics that described the global economy shuddering to a sudden halt. Economic distress shows up quickly in the employment statistics. The April non-farm payroll report recorded a stunning loss of 20 million jobs – almost 1 in 7 U.S. workers lost their jobs in one monthEven in the face of this disaster, the S&P500 was up 12% by the end of the month. 

Although the Federal government’s stimulus is widely credited with arresting the economy’s sharp decline, most people assume that personal income has similarly collapsed along with employment. This is not the case. 

The chart below shows the personal income “bridge” from September 2019 to September 2020. Disposable Personal Income – that is, including the effects of any government transfer payments such as unemployment insurance, is $1TN higher than a year ago. $800BN of that is due to direct payments by the Federal government. But even Wages and Salaries are $56BN higher over this period. 

Meanwhile, the economy has lost ten million jobs. In 2019 we averaged monthly gains of 178K None of us have ever witnessed a period like this, with employment and personal income heading in sharply different directions 

It’s surprised economists for most of the year. The failure of Congress to pass an additional stimulus plan has created fears of more widespread hardship. But the vaccine news from Pfizer and Moderna will likely temper the more extreme stimulus proposals.  

Meanwhile, energy is becoming the new momentum sector. 

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Fighting Climate Change Is Hard

Incoming President Biden is expected to take the U.S. back into the Paris Climate Agreement, which will mean policies to reduce emissions of GHGs (Green House Gases) will figure in Administration policy.  

Polls showed that two thirds of registered U.S. voters described climate change as “somewhat” or “very” important in how they voted. As we saw last week, opinion polls were poor predictors of the election, Democrats received a substantially smaller share of the vote than this poll would have suggested.  

survey last year found that 68% of Americans wouldn’t even pay $10 a month in higher utility bills to combat climate change. It seems fair to say that, beyond a small group of climate extremists, support for green policies doesn’t have widespread economic support. The Democrats’ weaker than expected electoral result reflects this.  

White House executive orders to combat climate change could even lead to a healthy debate about where emissions are growing and the cost of solutions. The two charts below are informative.  

The first is from a 2018 paper called “Measuring Renewable Energy As Baseload Power” published in 2018 by the University of North Carolina. Proponents of solar and wind power often superficially claim that renewables are now cheaper than natural gas power plants. A true comparison needs to account for their intermittency (it’s not always sunny and windy). So the authors walk through a cost comparison of a 650 Megawatt (MW) Natural Gas Combined Cycle (NGCC) power plant running 85% of the time with solar or wind on equivalent terms. The 85% uptime for an NGCC plant allows for maintenance approximately 55 days a year. Solar intermittency means it’s producing power only 21% of the time, peaking around noon.  

A correct comparison between the two requires combing the renewables power production with either (1) a smaller NGCC plant, or (2) battery storage. This raises the solar plus model to the 85% capacity utilization of the NGCC plant. 

The study compares the cost of an NGCC plant with four different combinations of solar and/or wind plus supplemental power.  

The point is that using renewables when they’re available can be cheap. But relying on them is not. California is finding that a purist approach to power generation of eliminating all fossil fuels plus nuclear is both more expensive and unreliable (see California Dreamin’ of Reliable Power). It’s not a combination many should find attractive.  

The second chart shows coal-burning power plants in the world’s top ten users. China, the world’s biggest emitter of GHGs, doesn’t just operate far more coal burning power plants than any other country. They’re also building almost as many new plants as the existing U.S. coal fleet. This issue receives very little media attention, although the FT did highlight it recently (see Climate change: China’s coal addiction clashes with Xi’s bold promise). This is why China is planning to increase its GHG emissions over the next decade.  

If the Administration pursues policies that impede the use of natural gas for power generation in favor of renewablesintermittency and China’s role in curbing emissions will receive more attention. It’s a debate worth having. 

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The Big Rotation Begins

Monday’s dramatic news on Pfizer’s vaccine triggered a sector rotation which could be enduring. A vaccine that’s 90% effective is a far better outcome than most had expected, bringing the prospect of an early end to lockdowns, self-quarantines and the rest of the Victorian-era public health measures we’ve come to accept.  

The ratio of the Nasdaq QQQ with the Russell 2000 is followed by many as a reflection of technology versus small cap value. Covid gave a boost to a long-established trend favoring tech stocks in March. The reversal of the past couple of days has caused this ratio to decisively cross its 200 day moving average to the downside. Given the vaccine news, it wouldn’t be surprising for this new trend to continue. 

Having lagged value stocks most of the year, energy is leading the way higher. The S&P Energy ETF (XLE) has jumped 16% since Monday morning, helped by a 10% rally in crude oil. The broad-based American Energy Independence Index (AEITR) is up almost 12% since Monday. Pipeline stocks are so undervalued that it doesn’t take much to move them higher.  

The recently announced buybacks buoyed sentiment, as well as helping neutralize the relentless selling by MLP fund investors (see Pipeline Buybacks Are Coming). Fund outflows have been persistent for most of the year, but the buybacks are big enough to absorb the typical outflows. Western Gas (WES) added to the growing list with a $250MM program yesterday. 

Long-suffering energy investors are wondering if the recent move up is the real deal or another head fakeThe election is likely to produce the best of both worlds – divided government with an instinctively moderate president (listen to Energy Executives and the Election). 

Georgia’s run-off for two senate seats will be heavily financed by both parties – without winning both races, the Democrats will be unable to push the more radically liberal elements of their platform (Green New Deal, fracking ban)  

In this political environment, long term capital commitments to new hydrocarbon production or related infrastructure are unappealing (see Why Exxon Mobil Investors Might Like Biden).  

The world relies on fossil fuels, and there is little chance of  that changing any time soon. Curtailed investment in new supply should lead to higher prices for oil & gas. Fewer new infrastructure projects will lead to less competition, as well as reduced capital needs.  

This will boost the pipeline sector’s free cash flow, which is already set to double this year (see Pipeline Cash Flows Will Still Double This Year).  

The style rotation has shown up in other areas too. Tech stocks have seemed a one-way bet, so it was no surprise that on Monday, Bloomberg’s US Pure Momentum Portfolio suffered its biggest ever one day drop. It lost over 3.5%, on a day the S&P500 rose 1.2%. MTUM fell another 1% yesterday.  

Over two days, Russell Growth has lagged Value by over 8%. As recently as Friday, Growth was 40% ahead of Value for the year.  

Pipelines may be the quintessential value play. The components of the AEITR still yield 8.9% on a market cap-weighted basis. 3Q earnings saw dividends paid once again. Energy Transfer (ET) was the only meaningful exception (see Why Energy Transfer Cut Their Distribution). 

A recovery in the pipeline sector is long overdue, and given valuations has enormous upside from current levels.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.


Pipeline Buybacks Are Coming

Pipeline companies have been reporting earnings. As has been the case recently, they’ve been generally coming in as expected, reflecting the stability in their underlying businesses. In many cases it’s hard to see much Covid impact at all. Williams Companies (WMB) reported 3Q adjusted EBITDA down 1% year-on-year.  Enterprise Products Partners (EPD) was similar.  

A bigger story has been the growing trend towards announcing buybacks. This is a visible confirmation of growing free cash flow (see Pipeline Cash Flows Will Still Double This Year, posted in May and remaining accurate ever since).  

EPD has had a buyback program in place for the past year. Kinder Morgan (KMI) and Energy Transfer (ET) have both said that buybacks are a possible way to return cash to shareholders in the future. More tangibly, MPLX announced a $1BN buyback last week. Targa Resources (TRGP) and Plains all American (PAGP) followed up with $500MM eachEnlink announced $100MM 

It’s beginning to look like a trend.  

Midstream energy infrastructure has been weighed down by a steady stream ooutflows from MLP-dedicated mutual funds and ETFs — around $6.5BN over the past year. With over $2BN in new buyback announcements just last week, this source of additional demand could well absorb future sales by funds. This would allow the increasingly positive cash flow story to unfold, lifting prices.  

An interesting perspective on the value of dividends was provided by Altus Midstream (ALTM). Operating with 5X Debt:EBITDA and questionable prospects in its natural gas gathering and processing business, it has been a target of short sellers for some time. Covid has reduced crude oil output in the Perman basin, thereby reducing the volume of associated natural gas which has allowed prices to rise.  

Higher prices are supporting volumes through ALTM’s gathering network, and next year Kinder Morgan’s new Permian Highway pipeline will improve producer economics by offering a new transportation option from the Waha hub to the Texas gulf coast.   

ALTM surprised the market by instituting a quarterly dividend of $1.50, starting next March. Forget the financial theory that dividends don’t matter – ALTM tripled in price on the announcement. Even after adjusting to the news, at $30 the stock will yield 20% when dividends start next year.  

With Republicans looking likely to retain control of the senate, pipeline investors can contemplate little prospect of any sweeping legislation that might harm the energy sector. But a President Biden is likely to use regulation and executive actions to further impede new construction. On Energy Transfer’s earnings call on Wednesday, executives commented that an extensive network already installed must have even more value when little new can be built. We discussed this and included clips from the earnings call on Friday’s podcast (listen to Energy Executives and the Election). We’ve dubbed it “Goldilocks Gridlock” from the perspective of the energy sector.  

We also provided a brief update of the post-election outlook in thSL Advisors Post-Election Energy Outlook webinar. 

Earnings, buybacks and divided government provided plenty of positive fundamental news for midstream energy infrastructure.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Exxon’s Contrarian Bet

On Wednesday Exxon Mobil (XOM) declared a quarterly dividend of 82 cents a share. Although this means 2020 will be the first year since 1982 that they haven’t raised it, the bigger question is whether they can sustain it.

We noted recently how energy investors could fare better under a Democrat administration (see Why Exxon Mobil Investors Might Like Biden). A White House looking for ways to combat climate change should cause energy executives to hunker down, constraining their desire to drill for oil and build new infrastructure. A pipeline owner should find this a welcome prospect, as less cash spent on new projects means more for buybacks, debt reduction and dividend hikes. XOM is positioning itself for such a scenario – they plan to increase oil and gas production from 4 million Barrels of Oil Equivalent per Day (MMBOED) currently to over 5 MMBOED by 2025. This bet is predicated on rising global demand driven by emerging economies combined with falling investment in new supply, as energy companies prepare for peak oil and the energy transition.

There’s something appealingly pragmatic about XOM’s positioning. Although growth in renewables gets all the attention, the world still relies on fossil fuels for more than 80% of its energy. In the U.S., the biggest increase in power generation in the first half of the year came from natural gas, not renewables. Most credible long-term energy forecasts show that the world will be using more of every type of energy, because developing countries want to raise living standards. The energy outlook embedded in XOM’s production plans is probably not consistent with the Paris Climate Accord. If you want to bet that the world will manage to live with a warmer climate, rather than achieve the reductions laid out by the UN’s Intergovernmental Panel on Climate Change, XOM might be a way to express that view.

If they’re wrong, that 82 cent dividend won’t last. Analysts estimate they need crude prices of at least $55 per barrel in order to generate enough cash to cover planned growth capex and pay their dividend. For now, they’re funding it with increased debt.

Given the energy sector’s sorry history of overinvesting in recent years, maintaining high dividends does impose greater financial discipline. It raises the required return on new spending, making dilutive projects less likely. Although financial theory teaches that dividends shouldn’t matter, investors increasingly recognize the protection against otherwise poor capital allocation decisions. That’s likely part of the reason XOM rose on Thursday, because it maintained a dividend that’s currently financed partly with debt.

Pipeline investors often must consider the viability of a company’s payout policy. The Alerian MLP ETF, AMLP, has cut by 50% since 2014. Although Energy Transfer (ET) just did the same early last week, the pipeline sector is entering a period of sharply rising Free Cash Flow (FCF). The trend towards reduced spending on new projects was well underway before Covid hit this year.

Energy has been chronically out of favor, so XOM and the American Energy Independence Index have tracked one another lower. Although the pipeline sector and XOM are both forecast to experience growing FCF, pipeline dividends will be comfortably covered by FCF while XOM’s will not, at least with current crude oil pricing. XOM offers a way to bet on higher crude. By contrast, pipeline stocks look cheap regardless.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Next Wednesday, November 4th at 1pm EST we’ll be hosting a post-election webinar to discuss the outlook for the energy sector. Click here to sign up.

Why Energy Transfer Cut Their Distribution

Energy Transfer’s (ET) 50% distribution cut announced late on Monday surprised most observers. Given the comfortable 1.4-1.5X DCF coverage this year and next, many felt that there was little pressure to reduce it. However, the persistently high yield (18% before the announcement), reflected widespread investor skepticism around its sustainability. Debt:EBITDA of 5X is higher than the prevailing 4-4.5X standard for investment grade names in the sector.  

The company’s press release provided no additional color, and the 3Q20 earnings call will be next Wednesday, when election results will dominate the news.  

Distribution cuts are rarely well received. Income-seeking investors who used to be the core investor base for pipelines have endured them for years. Few could be shocked by one more. The payout on the Alerian MLP ETF (AMLP) is 50% below its peak of February 2016. Since ET is a 10.1% position in its index, the Alerian MLP Infrastructure Index (AMZI)AMLP is likely to cut a little more. MLP-dedicated funds run by Invesco are also significant ET holders, highlighting the problems such funds face with a shrinking pool of investable names (see Why MLP Fund Investors Should Care When They Change).  

Selling on Tuesday following the announcement likely reflected disappointment from investors who had believed the DCF coverage meant it was secure.  

The problem was that too few investors believed the distribution would be maintained, and this became a self-fulfilling prophecy. The high yield meant it was a waste of money to keep paying it. The stock is too cheap to be used as an acquisition currencyRetiring CEO Kelcy Warren’s substantial income from the distribution was one of the arguments for its continuation, but he can probably get by on less.  

A few weeks ago we contrasted the negative view of ET held by equity investors with the relative equanimity shown by their bond yields (see The Divergent Views About Energy Transfer). As the chart shows, strong differences of opinion about ET persist across the capital markets. A ten year bond issued by ET in January last year trades above par, after falling sharply earlier this year. By contrast, ET’s stock price remains at just half the level it was when the bonds were issued.

This is a theme with investment grade pipeline stocks. Enterprise Products Partners (EPD) is another example of a company whose bonds reflect a much more positive outlook than does their stock (see Stocks Are Still A Better Bet Than Bonds).  

Pipeline stocks have long abandoned any connection with Miller-Modigliani and the Capital Asset Pricing Model (CAPM). Theoretically, investors should be indifferent to leverage or dividends for example, but in practice they are not. Once the reactive selling from those who liked the former 18% yield is finished, investors will see a company with more financial flexibility. They could use some of the cash freed up by the distribution cut to repay debt, although their bonds are expensive. Or they could initiate a stock buyback, directly confronting their low valuation.  

We’ll need to wait until next Wednesday to learn more. ET has often been criticized for exploiting its investors where possible. The convertible preferreds they issued to management in 2016 following the ill-fated pursuit of Williams Companies (WMB) permanently cost them trust in the marketplace, and is a reason for their continued depressed stock price (see Energy Transfer’s Weak Governance Costs Them). Newly promoted co-CEOMackie McCrea and Tom Long have an opportunity to demonstrate good faith with investors.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Hydrogen Lifts an LNG Company

Few would believe there’s a midstream energy infrastructure stock that’s tripled this year, but New Fortress Energy (NFE) has done just that. Happily, it’s a component in the American Energy Independence Index (AEITR). This year’s strong performance has NFE approaching a top ten position, since AEITR is market cap weighted.  

NFE was founded in 2014 by Wes Edens, already a billionaire as a co-founder of Fortress Investment Group (FIG). They transport Liquified Natural Gas (LNG), and have five facilities located around the Caribbean and in Miami. NFE claims that their innovative use of smaller LNG ships makes clean natural gas available to ports that otherwise don’t have the infrastructure. These vessels are called Floating Storage Regasification Units.  NFE’s investor slides emphasize their ability to bring cleaner-burning natural gas to island nations such as Jamaica, thereby reducing their reliance on dirtier, oil-based fuels for power generation.  

NFE went public last year as an LLC electing to be taxed as a corporation, and earlier this year converted to a regular c-corp. Their stock performance was unremarkable – that is, it tracked AEITR – until early July when it took off.  

Although NFE already had a positive environmental story to tell, in recent months they have begun discussing plans to transport hydrogen, an emission-free fuel. So far, management has done little beyond muse on conference calls about their interest in hydrogen and how great it would be if the economics allowed it to compete with natural gas. There are no hydrogen-related revenues, and analysts don’t expect the company to make substantial capital commitments in this area.  

Nonetheless, there’s little else to justify NFE’s recent meteoric rise beyond its stated interest in hydrogen. The word came up 32 times in the 2Q earnings call on August 3rd (up from 12 in the 1Q call), although obliging questions from sell-side analysts helped. CEO Edens noted that, “75% of all of the elements in the universe are hydrogen, 24% helium, 1% other. So the world is full of hydrogen.” 

This doesn’t mean NFE won’t access new technology that makes hydrogen a commercially viable fuel. Pipelines and other infrastructure dedicated to natural gas might be repurposed to handle this zero-emissions fuel, which would transform the malaise felt by investors towards the sector. But NFE’s stock has shot up recently mostly on the hope of a breakthrough. NFE’s green hydrogen division (named Zero) has no revenues. But just having a business unit with that name can only help an energy company. 

NFE’s recent rise hasn’t been overlooked by other midstream companies. Kinder Morgan (KMI) chairman Rich Kinder included the words “green hydrogen” when he opened Tuesday’s earnings call. 

Thursday’s presidential debate touched on climate change. Regardless of who you’re voting for, there can’t be much doubt that Trump won the exchange. Biden’s talk of a moral imperative to reduce carbon emissions isn’t likely to resonate when the economy is virus-ravaged. Trump correctly noted that China and India plan to keep increasing their CO2 emissions for at least another decade. China burns half the world’s coal.  

This component of climate change realpolitik receives little popular attention.  Climate change policies aren’t currently costing much, unless you live in California where electricity is greener, more costly and less reliable. But if America does adopt policies to aggressively reduce emissions, Trump’s point is that many will balk at higher domestic energy prices when the biggest emitters remain focused on raising living standards. A Biden victory will lead to a more vigorous debate, exposing a huge flaw in the Paris agreement. 

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Why MLP Fund Investors Should Care When They Change

MLPs have been losing relevance to the midstream energy infrastructure sector for years. The Shale Revolution caused them to evolve from reliable generators of income to growth-seeking enterprises. As upstream companies plowed money into drilling, pipeline companies felt compelled to add new infrastructure to service them. The capital spending spigot had already been ratcheted down since 2018, with investors rebelling against the culture of always building. The hit to demand from Covid accelerated a trend already in pace.  

MLPs represent around a third of the pipeline business. This has left MLP-dedicated funds increasingly challenged to find enough names to build out a portfolio. It’s a dilemma we’ve forecast for a long time (see The Uncertain Future of MLP-Dedicated Funds, April 2018). Such funds, most notably the Alerian MLP ETF (AMLP), were already burdened with an inefficient structure (see Uncle Sam Helps You Short AMLP, July 2018).  

The MainStay Cushing MLP Premier Fund (CSHAX) has decided to bite the bullet and abandon their anachronistic structure. In recent weeks they’ve been quietly informing clients that they plan to limit MLPs to 25%, because of the “significant contraction” of MLPs. It’s taken them longer than it should, but they’ve accepted that the MLP business has changed. Serial distribution cuts imposed on income seeking investors have lost those investors to the sector for good.  

CSHAX is around $500MM in AUM. Bringing their MLP holdings below 25% will require them to shed 75% of their portfolio, around $375MM, over period of months. MLP funds have seen around $6BN of outflows in the past year, and this has weighed on prices. Even so, the CSHAX repositioning should be manageable. 

But what if other MLP funds reach the same conclusion? The Invesco Steelpath family of MLP funds is over $3.5BN. Center Coast and Goldman each have another $800MM. And AMLP is $3.3BN. There’s over $13BN invested in flawed, MLP-dedicated funds.  

MainStay Cushing’s move is logical, but nobody will want to be the last one jumping. They’re not the first either. Some smaller closed end funds have combined and become RIC-compliant by limiting MLPs to 25%. The Kayne Anderson MLP/Midstream Investment Company recently became the Kayne Anderson Energy Infrastructure Fund (still KYN). Dropping MLPs is a developing trend. 

It should induce investors in all MLP-dedicated funds to ponder their fund’s future. If bigger funds follow MainStay Cushing, the MLP sector could find itself having to absorb an indigestible amount of sales. Alerian calculates the market cap of MLPs at $139BN, but it’s only $72BN when adjusted for float. For example, the Duncan family’s 32% ownership of Enterprise Products Partners (EPD) doesn’t provide any liquidity. The remaining MLP-dedicated funds are almost 20% of the market. 

MLPs are cheap by any reasonable measure. We’ve noted the yawning gap between EPD’s debt and equity yields (see Stocks Are Still A Better Bet Than Bonds)Bond and stock investors are poles apart in their assessment of the sector. But the risk investors in MLP-dedicated funds face is that portfolio shifts by competitor funds depress MLP prices, driving down their own fund’s NAV. 

The nearterm future of MLP-dedicated funds is unclear. But the time for such vehicles has passed, and it seems inevitable that funds invested in midstream infrastructure will limit MLPs to 25%. You just don’t want to be in the last fund to decide to make the shift.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.