Archive for category: MLPs

Energy infrastructure roared higher during the first six trading days of January. After four days, the sector had recovered December’s losses. Two days later, it had almost recouped all of 2018. It was a complete reversal of last month, when slumping equity markets dragged pipeline stocks lower.

It’s looking increasingly likely to us that automated trading strategies relying on complex algorithms (“algos”) are at least part of the reason.

Last year MLPs had already been laboring under the weight of serial distribution cuts. For example, AMLP’s payout is down by 34% since 2014. Incidentally, this must be the worst performing passive ETF in history. Since inception in 2010, it has returned 4% compared to its index of 25%. Its tax-impaired structure is part of the reason (see Uncle Sam Helps You Short AMLP).

For the first nine months of last year, crude oil and energy infrastructure moved independently of one another. Investors who painfully recall the 2014-16 energy sector collapse complained that rising crude prices didn’t help, but as the chart shows, they rallied together in the Spring but parted company in late Summer as the oil market started to anticipate the re-imposition of sanctions on Iran. Crude and pipeline stocks are intermittently correlated, because their economic relationship is weak. Crude sometimes drives sentiment, which can quickly change.

However, when crude dropped sharply following the Administration’s waivers allowing most Iranian exports to continue, energy infrastructure followed. Pipeline company management teams routinely show very limited cash flow sensitivity to commodity prices, and 3Q18 earnings reported in October/November were largely at or ahead of expectations. Nonetheless, an algorithm incorporating the 2014-16 history would expect MLPs to follow crude when it drops sharply, and would act accordingly. Trading systems bet on falling MLPs following crude, and sold.

In late December crude reversed, and trading systems at a minimum are closing out short pipeline positions if not going the other way. Hence the blistering early January recovery. The fundamentals were good in December, and remained so in January. Any change was imperceptible.

This is conjecture. It’s impossible to obtain hard data to support or refute this theory of market activity. So consider our perspective as a money manager in the energy infrastructure sector, in daily contact with clients and potential investors discussing the outlook. In December, callers were frustrated. The apparent disconnect between fundamentals and stock prices was confusing, troubling. What were they overlooking? What were we missing? Many held, but some didn’t. Frustrated at losses they couldn’t explain, having lost faith with repeated bullish analysis, the sector saw more outflows than inflows. Potential buyers noted compelling values, but usually were dissuaded by continued sector weakness. Unable to comprehend the inability of good financial performance to boost prices, many opted to wait. Tax loss selling towards the end of the year exacerbated.

The turn of the calendar coincided with a modest bounce in crude oil, as reports surfaced that the Saudis were sharply reducing crude exports to the U.S. Current prices are creating for them a substantial fiscal gap.

Conversations with clients and prospects have completely turned. Now callers want to know if there will be a pullback. Is the rally for real? Flows have also reversed. One day last week inflows to one of our funds outweighed outflows by 100:1. In December there were no buyers. In early January there are no sellers.

I was prompted to consider events in this light by a recent article in the Financial Times (Volatility: how ‘algos’ changed the rhythm of the market). Philosophically, I’m inclined to believe that automated trading simply does what humans do, just better and more cheaply. However, there is a less benign feature in that algos are also exploiting the inefficiences of humans. Michael Lewis showed this in Flash Boys by examining how high frequency trading systems will see market orders placed and race to snatch the best price before the limit order is executed. This happens in fractions of a second. But humans can also be outwitted over longer periods. December saw the biggest ever monthly outflows from mutual funds, capping an unusual year in which almost every market was down.

There was some bad news. The trade dispute with China is slowing growth there, and S&P500 earnings forecasts are being revised lower. The government is shut down. Fed chairman Powell sounded more hawkish before walking back his comments (see Bond Market Looks Past Fed). But these developments scarcely seem to justify record mutual fund outflows. There have been far worse environments for stocks.

Hedge fund veteran Stanley Druckenmiller said, “These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me.” Philip Jabre closed his eponymous hedge fund, complaining, “…the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerized models.”

The Financial Times quoted a senior JPMorgan strategist as saying that, “…we just have to accept that equity markets are almost fully automated.” JPMorgan estimates that only 10% of trading is generated by humans.

The Wall Street Journal reported that trend-following trading systems shifted “…from bullish to bearish to a degree not seen in a decade, according to an analysis of algorithms that buy or sell based on asset-price momentum.”

The WSJ also blamed volatility in commodity markets on computerized trading, citing a report that “…Goldman Sachs attributed the recent volatility to algorithmic traders exerting more influence in the oil market.”

The growth in algorithmic trading seems to be coinciding with a drop in discretionary trading by humans, which probably reflects that computers are beating humans in certain areas.

On one level, algos are designed to exploit human frailties by anticipating them. Perhaps they even cause them. It seems many people had little reason to sell in December beyond fear of losing money. Successful algos by definition attract capital, increasing their ability to move markets and hunt for more inefficiencies. Humans, at least those who adjust their positions too frequently, are becoming prey. One result could have been systematic shorting of pipeline stocks in response to crude’s sharp drop, because it worked in 2014-15. Sector weakness certainly couldn’t be traced back to recent earnings reports. Investors who sold during this time because they tired of losing money added to the downward pressure, reinforcing the trend. This would also have provided confirmation to the algorithms that the signal worked.

Since computerized trading isn’t going away, survival for the rest of us lies in being less sensitive to market moves. Examining fundamentals and staying with a carefully considered strategy that doesn’t rely on the market for constant confirmation of its correctness is the human response to algos.

Energy infrastructure remains attractively valued. Free cash flow yields before growth capex (i.e. Distributable Cash Flow) are over 11%. We estimate dividends will grow on the broadly based American Energy Independence Index this year by mid to high single digits. The long term outlook for the sector remains very good.

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).

MLPs have become more attractively priced compared with other income-oriented sectors. One way to see this is to compare the trailing four quarter yield. REITs and utilities have remained within a fairly narrow range, while MLPs rose sharply during the 2014-15 oil collapse. After a partial recovery, weakness over the past year or so has caused MLP yields to drift higher again.

For many years prior to the 2014 sector peak, MLP yields were around 2% above utilities. Currently, they’re around 5% wider. This ought to attract crossover buying from income-seeking investors, switching their utility exposure for MLPs, but so far there’s limited evidence of this happening. Although the yield advantage over REITs isn’t quite as dramatic, the same relative value switch exists there too.

The broad energy sector has remained out of favor. MLPs used to track utilities and REITs fairly closely until 2014 when they followed energy lower. However, even compared with energy, midstream infrastructure remains historically cheap. Research from Credit Suisse shows that on an Enterprise Value/EBITDA basis, pipelines are the cheapest vs the S&P energy sector they’ve been since 2010.

The Shale Revolution has challenged the MLP model in ways that few anticipated. Increasing U.S. output of crude oil, natural gas liquids and natural gas is creating substantial benefits for the U.S. Improved terms of trade, greater geopolitical flexibility and reduced CO2 emissions underpin America’s greater willingness to buck the global consensus. However, investors are still waiting for the financial benefits. This is partly because the capital investments required have demanded more cash. E&P companies had to fund investments in new production, which drew criticism that they were over-spending on growth. Similarly, MLPs pursued many opportunities to add infrastructure for transportation, processing and storage in support of new production. All this left less cash to be returned to investors through buybacks and dividends. It remains the biggest impediment to improved returns.

Unlike MLPs, both utilities and REITs have both been increasing dividends. Even the energy sector has raised payouts, although this was achieved in part through less spent on stock buybacks, which has led their investor base to insist on improved financial discipline. MLPs have both increased cash flows and lowered distributions.  Oil & gas executives seem unable to turn down a growth project.

By contrast with the income sectors with which MLPs used to compete, they have been lowering dividends. This makes yield comparisons less reliable, and likely explains why there’s been little evidence of shifts away from lower-yielding, traditional income sectors.

It’s why the biggest pipeline companies have dropped the MLP structure in favor of becoming corporations, so as to access the broadest possible set of investors. However, that hasn’t always worked out either, as the history of prior distribution cuts continues to weigh on sentiment. Williams Companies (WMB) is an example of a corporation that combined with its MLP, Williams Partners (WPZ). WMB CEO Alan Armstrong claims to be puzzled by persistent stock weakness. Meanwhile, legacy WPZ investors well recall the multiple distribution cuts they endured along the way (see Pipeline Dividends Are Heading Up).

In our experience, one of the issues that makes current investors nervous and gives new ones pause is that they don’t understand the continued weakness when volumes are up and management teams bullish. In December most sectors were down sharply, and global growth concerns depressed the energy sector along with most others. But for most of 2018 and certainly the second half, the disconnect between strong operating performance and poor security returns has perplexed many.

We’ve sought to explain this, and regular readers will know we’ve concluded that reduced distributions are the most important factor. The investor base was originally drawn for stable income, which in recent years MLPs have failed to provide. The Shale Revolution, perversely, has so far been a lousy investment theme even while it’s been terrific for America.  The charts in this blog post present a narrative now familiar to many.

Next year we expect rising dividends for the companies in the American Energy Independence Index to draw increasingly favorable attention to the sector. Although the MLP model no longer suits most of the biggest operators in the industry, midstream energy infrastructure offers compelling value. The best way to participate is by investing in the biggest companies, which are mostly corporations but do include a few MLPs. When the sector begins its recovery, it’ll start from far below fair value.

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).

Weakness in the pipeline sector over the past couple of years has caused soul-searching and changes to corporate structure. Incentive Distribution Rights (IDRs), which syphon off a portion of an MLP’s Distributable Cash Flow (DCF) to the General Partner (GP) running it, have largely gone. Many of the biggest MLPs have abandoned the structure entirely, leaving its narrow set of income-seeking investors to become corporations open to global institutions.

The debate among investors, management and Wall Street about how to unlock value received some useful ideas recently from Wells Fargo. In a presentation titled The Midstream Conundrum…And Ideas For How To Fix It, they make a persuasive case that stock buybacks offer a more attractive use of investment capital than new projects.

This would be a significant shift for MLPs. As recently as five years ago, they paid out 90% or more of their DCF to unitholders and GP (if they had one). The Shale Revolution was only beginning to demand substantial new infrastructure, so they had little else to do with their cash. New projects were funded by borrowing and by issuing equity through secondary offerings.

Shale plays were in regions, such as the Bakken in North Dakota and the Marcellus in Pennsylvania/Ohio, inadequately serviced by pipelines. This broke the model, because the amounts of investment capital required grew substantially. The capital markets loop of paying generous distributions while simultaneously retrieving much of the cash through new debt and equity was no longer sustainable. Dozens of distribution cuts and lower leverage followed, leading to projects being internally financed. This is the new gold standard for the sector – reliance on external capital to fund growth is out.

Wells Fargo takes this logic a step further, asking why excess cash always needs to be reinvested back in the business rather than returned to investors via buybacks. In spite of professed financial discipline, midstream management teams invariably find new things to build, all expected to be accretive (i.e. return more than their cost of capital). Pipeline companies are not alone – the entire energy sector has been dragged by investors to prioritize cash returns over growth. But MLPs rarely buy back stock. Free of a corporate tax liability, MLP distributions aren’t subject to the double taxation of corporate dividends, so raising payouts is a simple way to return cash.

The Midstream Story over the past several years has largely been about financing growth projects. Investor payouts were sacrificed, but rarely did a company admit that its internal cost of capital was too high to justify a new initiative. Wells Fargo is challenging management teams to regard buying back their own stock as a more attractive use of capital than building or acquiring new assets. This is capital management 101 for most industries, but unfamiliar terrain for pipeline stocks. Growth is embedded in the culture. The original justification for the GP/MLP structure with IDRs was to incent management to grow the business. CEOs in other industries find the motivation without such complexity.

In October, virtually every 3Q18 earnings call included an optimistic outlook from management, usually coupled with disbelief at the continued undervaluation of their stock. Attractive valuations mean a high internal cost of capital. Valued by DCF, or Free Cash Flow (FCF) before growth capex, midstream yields are in some cases higher than many companies’ stated Return on Invested Capital (ROIC) targets. Moreover, historic ROIC for the industry has often turned out lower than promised, although it has been improving.

Energy Transfer’s (ET) 16% DCF yield almost certainly offers a higher return than all but their best projects, and suggests they should be repurchasing stock. SemGroup’s (SEMG) DCF is 20%, twice the industry’s historic ROIC.

Growth caused the past four  years’ upheaval, and today’s low valuations are the result. Capital discipline has been less present than CEOs often claim, which is why they’ve apparently responded coolly to Wells Fargo’s buyback recommendation.

DCF yields of 10-14%  or more (as with ET’s 16%) are dramatically higher than FCF yields of 3%, because DCF measures cash generated before funding for growth projects while FCF is after.  FCF yields are set to rise sharply over the next few years, but this crucially relies on new investment coming down. The industry has a habit of showing that peak spending on new projects is imminent, only to push that back another year. 3Q earnings calls saw 2019 estimated capex creep up by almost 20%.

2018 is the fourth year of distribution cuts for MLPs, as reflected in the Alerian MLP ETF (AMLP). Corporations have fared better, and next year we expect dividends on the American Energy Independence Index to grow by 8-9%. If midstream companies are as financially disciplined as they claim, they’ll follow the advice from Wells Fargo in evaluating stock buybacks alongside new investments under consideration. It would complete their metamorphosis into more conventional companies.

We are invested in ET and SEMG.

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).

Around this time of the year we typically write about MLP seasonals. That’s because the “January effect” has been an enduring pattern of investor activity, far more pronounced than in the broader equity market. Prices would reliably dip in November before firming in December and shooting higher in January. This was due to the combination of income-seeking individual investors with K-1s. Because of the additional tax preparation costs, if you’re planning to sell an MLP in January, you might as well act in December and avoid one more K-1. Similarly, a December purchase delayed until January also avoids a K-1.

Quite possibly, the natural inclination to take stock of life, including investments, around the holiday season resulted in a decision to allocate cash to MLPs. Two years ago, in Give Your Loved One an MLP This Holiday Season, we noted the historic pattern and why purchasing MLPs in early December had worked so consistently.

Although the year-end pattern was most pronounced, there’s also an intra-quarter one. MLP investors love their income. Distributions tend to be declared in the first month of the quarter, payable a few weeks later. Sellers tend to hang on long enough to be a holder of record for the quarter, creating the Jan/Apr/Jul/Oct cycle of positive months.

Much has changed over the past five years. MLPs can no longer be relied upon for steady income. The Alerian MLP ETF (AMLP) recently cut its distribution again, resulting in a 34% cumulative reduction since 2014. Not only did some MLPs with high yields cut their dividends outright to fund growth projects and reduce leverage, but many were purchased by their much lower yielding parent companies, providing “backdoor” distribution cuts to MLP. The consequent betrayal of income-seeking investors has had many casualties, including still-depressed sentiment oblivious to attractive valuations.

Another change has been the breakdown of the seasonal pattern. Having been mistreated, income-seeking investors no longer act so predictably. Over the past five years the January effect has completely gone. So has the quarterly pattern – years ago, when the sector was stable and fairly unexciting, holding your investment a few more weeks so as to get that extra distribution wasn’t inordinately risky. MLP investors have learned to appreciate risk differently, and it’s clear that the calendar bears very little on the timing of today’s buyers and sellers. What’s striking about the past five years is both the randomness of the monthly returns, as well as that the average month is -0.3%. From 1996-2013 it was +1%.

The loss of the seasonal pattern is further evidence that the traditional investor, with her predictable habits developed over years of happy results, has left. It’s why the sector is cheap, because the former buyers have fallen out of love. Thus spurned, large MLPs have converted to corporations in search of new suitors, such that less than half of U.S. midstream infrastructure now retains the MLP format. Many believe the MLP model is irretrievably broken.

Eventually, and possibly quite soon, rising dividends will draw in a new set of buyers. They’ll buy corporations that were formerly MLPs, as well as some of the remaining MLPs. They’ll rely on discounted cash flow analysis (see Valuing MLPs Privately — Enterprise Products Partners). They’ll look beyond the betrayals (see Kinder Morgan: Still Paying for Broken Promises). They’ll find a sector with 11% free cash flow yields before financing new projects, and dividend yields of 6%+ growing at 10% (our 2019 forecast for the American Energy Independence Index).

We are long EPD and KMI. 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).

If pipeline stocks moved with natural gas rather than crude oil, their long-suffering investors could look back on a good week. On Tuesday crude was down $5 per barrel for the week, before recovering $2 by Friday. It’s tumbled $20 since early October, bringing Brent Jan ’19 to $66. By contrast, the Jan ’19 natural gas contract stormed out of its $2.90 to $3.50 per Thousand Cubic Feet (MCF) range that has constrained it all year, almost reaching $5 on Wednesday. Rarely have oil and gas been so disconnected.

The energy sector moves to the rhythm of crude. It’s is a global commodity, relatively easy to transport, which allows regional price discrepancies to be arbitraged away. Oil can move by ship, pipeline, rail or truck. Transportation costs vary from a few dollars per barrel for pipeline tariffs or waterborne vessel to $20 or more by truck. Although Canada’s dysfunctional approach to oil pipelines has led to deeply depressed prices, in most cases transport costs are a portion of the cost of a barrel.

By contrast, natural gas (specifically methane, which is used by power plants and for residential heating and cooking) generally only moves through pipelines or on specially designed LNG tankers in near-liquid form. Long-distance truck transportation isn’t common because liquefying methane to 1/600^th of its gaseous volume requires thick-walled steel tanks. Methane moved as Compressed Natural Gas (CNG) is only 1% of its normal volume (i.e. requires 6X more storage volume than LNG) which generally renders long-haul truck transport uneconomic. LNG shipping rates from the U.S. to Asia are $5 or more per MCF, more than the commodity itself. The 10-15,000 mile sea journey is worth it because prices in Asia are $8-15 per MCF, compared with normally around $3 per MCF in the U.S.

The result is that natural gas prices vary by region far more than crude oil.

There are price discrepancies within the U.S. too. The benchmark for U.S. natural gas futures is at the Henry Hub, located in Erath, LA. This is where buyers of $5 per MCF January natural gas can expect to take delivery. By contrast, 700 miles west in the West Texas Permian basin, natural gas is flared because there isn’t the infrastructure to capture it. Gas is flared because it’s worthless. Mexican demand is coming, but construction south of the border is running more slowly than expected.

The price dislocation in U.S. natural gas highlights the ongoing need for additional pipeline and storage infrastructure. Price differences in excess of the cost of pipeline transport translate into pipeline demand. Although the spike in Jan ’19 natural gas futures reflects a temporary supply shortage that can’t be alleviated by a new pipeline given multi-year construction times, such events are generally good for  midstream energy infrastructure businesses.

The oil price dislocation was at least partly due to hedging of option exposure by Wall Street banks that had sold put options to producers, such as Mexico. It has very little to do with midstream infrastructure. Having fretted for months over U.S.-imposed sanctions on Iran, the market was surprised by waivers that are softening the blow for Iran’s oil customers. It’s likely to create a reaction (see Crude’s Drop Makes Higher Prices Likely).

Long term forecasts of natural gas demand are less varied than for crude oil, and are driven by Asian consumption at the expense of coal for electricity production.  Crude oil demand forecasts vary more, generally because of differing expectations for electric vehicle sales. Although both are growing, a bet on natural gas looks the safer of the two.

Nonetheless, crude oil moves the energy sector and U.S. pipeline stocks tag along. On Tuesday when crude oil was -6.6%, the S&P Energy ETF (XLE) and Williams Companies (WMB) both slid 2.3%. Jan ’19 natural gas was +9.1%. WMB derives virtually all its value from transporting and processing natural gas and natural gas liquids. Its inclusion in XLE probably causes it to move with the sector more than its business would suggest.

3Q18 earnings for pipeline companies have been largely equal to or better than expectations. The fundamentals remain strong – investors continue to ask when sector performance will reflect this. Although the recently declared dividend on the Alerian MLP ETF (AMLP) is 34% below its 2014 level, we expect corporations will start increasing dividends, with the American Energy Independence Index likely to experience 10% growth in 2019.

We are long WMB and short AMLP.