Archive for category: MLPs

MLP valuations show that the trust of the traditional MLP investor has been lost, perhaps irretrievably. In Kinder Morgan; Still Paying for Broken Promises, we showed how that company’s history of investor abuse via two distribution cuts and an adverse tax outcome continues to weigh on its stock price. In Magellan Midstream: Keeping Promises But Still Dragged Down by Peers, we showed how even well-run companies that have honored promised distributions remain hampered by the abuse of others in the sector. The Alerian MLP ETF (AMLP) lowered its quarterly dividend again last week, by 7.5%. It’s now 34% below its 2014 high. The persistent cheapness of pipeline stocks reflects understandable wariness by MLP investors, who bought for the tax deferred income and had it partially removed.

Valuing such stocks on yield alone inadequately captures the past history of distribution cuts. Another common metric, EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization), is a blunt tool making little distinction between appreciating versus depreciating assets, or long term versus short term contracts.

Private equity buyers tend to look at cashflows. Using Enterprise Product Partners (EPD) as an example, Discounted Cash Flow (DCF) analysis reveals underappreciated value. DCF is often used to refer to an MLP’s Distributable Cash Flow, cash available for paying distributions to investors. To avoid confusion, in this article we will only use DCF as initially defined, the present value of future cashflows

EPD is the largest MLP. It is one third owned by the Duncan family and its well respected management team is ably led by Jim Teague. Their pipelines, storage assets and processing facilities handle crude oil, natural gas, natural gas liquids (NGLs) and refined products. They have a huge presence in along the gulf coast and include vertically integrated businesses that, for example, capture, moves, fractionate and export ethane.

EPD’s P/E ratio is unremarkable. Based on a consensus estimate of $1.67 for 2019, they trade at 16X, approximately the same multiple as the S&P500.

EPD’s EV/EBITDA is 11X. By comparison, KMI is 9.4X (penalized for past transgressions) while Oneok Inc (OKE) is at 14.7X, still feeling the love after last year’s successful conversion from an MLP to a corporation. Magellan Midstream (MMP), subject of last week’s blog, is 12.6X. On this measure, EPD could be described as moderately cheap versus its peer group.

While those traditional measures of valuation are unexciting, DCF analysis reveals a truly undervalued asset. Below is simplified look at cash flow analysis based on consensus EBITDA estimates:

2018: $7.0BN

2019: $7.4BN

2020: $7.75BN

2021: $8.3BN

2022: $8.65BN

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2019-22 Total $32.1BN

Financing EPD’s $26BN in debt costs $1.17BN (4.5% borrowing rate) annually. This year they’ll generate around $5.83BN in cash before taxes (which they don’t pay as an MLP). Depreciation and Amortization are non-cash expenses that typically don’t reflect the growing value of their assets, which is why earnings multiples such as P/E aren’t that useful.

For example, EPD owns underground salt caverns in Mont Belvieu, used for storing NGLs. This is wholly different than, say, a coal-burning power plant, which is why EV/EBITDA comparisons with utility stocks make little sense. Pipelines, when properly maintained, generally appreciate in value. As communities grow up around and over them, and other pipelines link into them, it becomes prohibitively expensive to build competing infrastructure.

With a Debt:EBITDA ratio of <4.0X, EPD is comfortably investment grade with a strong balance sheet. This allows them to rely on debt to finance their backlog of new projects. The Shale Revolution continues to create demand for new infrastructure in support of America’s growing production. Companies like EPD are financing and building it.

EPD’s backlog of new projects over the next four years is estimated at $9.5BN and they’re expected to spend $1.35BN in maintenance capex, which is money spent on their existing assets to maintain their capability.

Because their EBITDA is growing, by 2022 they’ll be able to carry debt of $32.44BN (2022 EBITDA of $8.65BN multiplied by their 3.75X desired Debt/EBITDA multiple – the low end of their guidance range of 3.75 to 4.0x Debt/EBITDA). That’s $6.44BN more than their current debt, which means they could, if they chose, borrow to finance ~60% of their $9.5BN in new projects and $1.35BN in maintenance capex, allowing more cash to be returned to equity holders. Only $4.4BN needs to be sourced from cash generated, so there is no need to issue dilutive equity.

Since new projects can be self-financed, it simplifies the valuation of the business. Suppose you had $59BN in cash with which to acquire the company at its current market capitalization (although as you’ll see, it’s doubtful the Duncan family would sell).

Over four years, the business will generate $32.1BN in EBITDA, less its interest expense of $4.7BN (4 times $1.17BN) and new investments funded from cash flows of $4.4BN, leaving $23BN. Returning this excess cash reduces the purchase price to $36BN by 2022. Deduct annual interest expense of $1.46BN (since there’s now more debt because of the growth projects) and maintenance capex of $350M, and the business is generating $6.84BN in cash, annually. On the $36BN purchase price, that’s a 19% cash flow yield.

Even half that cash flow yield would be attractive, which would value EPD 20% above its current market cap after paying out ~40% of its market cap in cash.

Future growth projects add further to the potential value. New energy infrastructure projects generally have required returns from as low as 10-12% to 20%+, depending on the degree of risk. Suppose EPD is able to reinvest 20% of its $6.84BN in annual cash, or $1.37BN, into new projects that have an expected unlevered return of approximately 14.3%. This equates to an EBITDA multiple of 7X (i.e. $100 invested to earn $14.30 is a multiple of 100/14.3, or 7) which is in the middle of the expected range for EPD’s current projects of 6-8X.  Sticking to their 3.75X leverage multiple, they could finance 54% of the project with debt (i.e. 3.75X desired debt multiple divided by 7X project multiple). The rest would come from equity, which would be sourced from current cashflow.

The result would be an investment of $1.37BN in equity ($6.84BN times 20%) along with $1.58BN in debt, for a total of $2.95BN. The 14.3% expected return on the $2.95BN project would generate $421MM annually, contributing to future EBITDA growth. After interest expense of $71MM (same interest rate of 4.5% assumed throughout) and maintenance capex of $21MM (estimated to be 5.0% of EBITDA), there would be $329MM of incremental cash flow for distribution.

By 2022 the business would have $5.47BN in annual distributable cash flows ($6.84BN in cash after interest & maintenance capex less the $1.37BN for new projects). Distributions to the owner would be growing at 4.8% annually. This comes from taking the $329MM generated by new projects, multiplied by an 80% payout ratio, since we’re assuming 20% of cashflow gets reinvested back in the business ($329 times 80% divided by $5.47BN = 4.8% growth rate).

By comparison, Utilities have a dividend yield 3.5% and REITs 4.25%, both with similar growth rates.  If EPD was simply valued at the same yield as REITs, the $5.47BN in 2022 cash flow would be worth $128.7BN. Add back the $23B in cash received to that point gets to $151.7BN. Discounted back to today at the risk free rate of 3%, gives a market value of $134.8BN. Divide by EPD’s current share count of 2.19BN units gives a price of above $60/unit, more than double today’s unit price.

Cash flow analysis presents a very different picture of MLP valuation than looking at conventional multiples such as P/E or EV/EBITDA.

The problem for public market investors is that EPD units come with a K-1. This generally rules out tax-exempt and foreign institutions, as well as non-U.S. individuals. The remaining investor base is narrow, consisting of older, wealthy Americans who want stable income. This group is still smarting from the 34% drop in MLP payouts, as reflected in AMLP. The MLP model may not be broken, but the trust of many of the traditional MLP investors is, which in effect means the same thing.

Cash flow analysis is how private equity buyers tend to value companies, although EPD is probably too big for such a take-private transaction. This illustrates why private equity firms often outbid the large midstream public companies for assets, despite the latter’s enormous competitive advantages of linking to existing integrated systems, and the associated synergies of maximizing utilization across their assets.

We are invested in EPD, KMI, MMP and OKE. We are short AMLP

Broken promises aren’t quickly forgotten. That’s the hard lesson being learned by pipeline company managements, as the sector remains cheap yet out of favor.

Kinder Morgan (KMI) reported good earnings on October 17th. Volumes were up, and they sold their Trans Mountain Pipeline (TMX), including its expansion project, to the Canadian Federal government. TMX is Canada’s only domestic pipeline that can supply seaborne tankers. All other pipelines lead to the U.S.

Canada’s landlocked energy resources are becoming a political football. Alberta wants to get its oil and gas to export markets, but neighboring British Columbia opposes the new pipelines necessary for Albertan crude to reach the Pacific coast. Caught between the two provinces, KMI sensibly sought an exit. The transaction was well timed, closing before cost estimates for completing the expansion  were ratcheted up and a court ruled that a new environmental study was required (see Canada’s Failing Energy Strategy). Canada’s taxpayers were on the wrong end of the deal.

Nonetheless, Rich Kinder opened the earnings call lamenting KMI’s valuation. He said, “I’m puzzled and frustrated that our stock price does not reflect our progress and future outlook.” We do think KMI is cheap, but the explanation lies in recent history. Before the Shale Revolution created the need for substantial new pipeline investments, KMI’s investor presentation reminded “Promises Made, Promises Kept.”

This turned out to be true only until financing new projects conflicted with paying out almost all available operating cash flow in distributions. Investors in Kinder Morgan Partners (KMP), the original vehicle, were heavily abused. They suffered two distribution cuts and a realization of prior tax deferrals timed to suit KMI, not them (see What Kinder Morgan Tells Us About MLPs). Former KMP investors, who are numerous, retain deeply bitter memories of the events and have lost all trust in Rich Kinder.

KMI was only the first of many. Distributions on Alerian’s MLP index have been falling for three years. Their eponymous ETF has cut its payout by 30%. Alerian CEO Kenny Feng, normally a reliable cheerleader for the MLP model, recently turned more critical, citing,”…significant abuses of [distribution growth] in the past…” The irony is that until late last year Alerian’s own website showed reliable distribution growth, completely at odds with what investors in their products were experiencing. They only corrected it when mounting criticism from this blog (see MLP Distributions Through the Looking Glass), @MLPGuy and others forced a humbling revision.

Too few commentators acknowledge the poor treatment of MLP investors (see MLP Investors: The Great Betrayal). Pipeline stocks are attractively valued but have been that way for some time. The legacy of broken distribution promises continues to cast a pall. KMI’s objective in abandoning the MLP model was to be accessible to a far broader set of investors as a corporation. So far, it hasn’t helped their stock price.

One explanation might lie in how they present their financial results. Distributable Cash Flow (DCF) is a term widely used by MLPs and retained by KMI even after it became a corporation. MLPs calculate their distribution coverage ratio, which is the amount by which DCF exceeds distributions. It’s somewhat analogous to a dividend payout ratio, albeit based on DCF not earnings. Kenny Feng notes that generalist investors aren’t familiar with DCF or its coverage ratio. It may be why KMI’s stock is languishing.

DCF is Free Cash Flow (FCF) before growth capex. MLPs have long separated capex into (1) maintenance, required to maintain their existing infrastructure, and (2) growth, for new projects. FCF, a GAAP term, is indifferent to the two types of capex and deducts them both. DCF (not a GAAP term) treats them differently by excluding growth capex, and is always higher.

Unsurprisingly, KMI regularly promotes its 11% DCF yield, which is higher than its energy infrastructure peer group. However, FCF is the more familiar metric, and is lowered by the subtraction of growth capex. Because KMI spent over 70% of its $4.5BN DCF on new projects, the remaining $1.4BN in FCF results in just a 3.3% FCF yield. This is still higher than the energy sector and certainly better than utilities (which are often negative because of their ongoing capex requirements). But it doesn’t stand out versus other sectors, and probably causes analysts to overlook the high DCF yield.

As a corporation, KMI continues to promote a DCF valuation metric used by MLPs, Using the more common FCF yield, it isn’t compelling. However, DCF seems reasonable to us given their business model.

To see why, consider yourself owning an office building. After all cash expenses, including maintenance and setting aside money annually to replace HVAC and other equipment, it generates $1 million in cash, annually. In real estate this is called Funds From Operations (FFO). Because you’re already deducting the expenses required to keep the building operating, and it’s most likely appreciating in value, it’s reasonable to value it based on the $1million recurring cashflow. A cap rate of 5% means you’d require at least $20 million before agreeing to sell it.

Now suppose you decided to redirect $700K of your $1 million annual cashflow towards buying a second building that you also plan to rent out. You still own a $20 million asset, and reinvesting some of that annual cashflow in a new building doesn’t affect the value of what you already own.

In this example the $1million in FFO is analogous to KMI’s DCF. It’s why they believe their stock is undervalued, because 11% is a high DCF yield. Their FCF is so much lower because they’re investing most of their DCF in new assets that will generate a return.

GAAP FCF doesn’t differentiate between capex to maintain an asset and capex to acquire a new one, which is why pipeline companies don’t dwell much on FCF. Moreover, properly maintained pipeline assets generally appreciate. As climate activists slow new pipeline construction in some states, it simply raises the value of nearby infrastructure that can serve the same need.

Critics may believe that DCF doesn’t reflect all the necessary maintenance capex that’s really required, or that the underlying assets are depreciating in value even while properly maintained, although there’s little if any evidence to support either claim. So KMI remains misunderstood.

The dividend might offer a more compelling story. Yielding 4.7%, it’s below the 5.8% of the broad American Energy Independence Index. Because of history, investors are understandably cautious in buying for the yield. But today’s $0.80 annual payout is expected to jump to $1 next year and $1.25 in 2020. This 25% annual growth will push the yield to 7.4% in two years, assuming no upward adjustment in the stock price. A rising dividend might finally vanquish the unpleasant memories of prior cuts, and draw in new buyers.

In spite of its attractive valuation, MLP ETFs and mutual funds don’t own KMI, because it’s not an MLP, providing another good reason to seek broad energy infrastructure exposure that includes corporations.

We are long KMI and short AMLP.

Last week Antero Midstream (AM) became the latest MLP to simplify their structure. This is further evidence of the declining opportunity set for MLP-dedicated funds, and cause for investors to seek exposure to energy infrastructure that goes beyond MLPs to include corporations (see The Uncertain Future of MLP-Dedicated Funds).

Like many MLPs before them, Antero is becoming a corporation. Broader institutional ownership and enhanced trading liquidity were cited as the reasons.

The benefits of being an MLP persist – our friend and regular commenter Elliot Miller would note that the tax benefits remain significant: MLPs don’t pay Federal corporate income tax, leaving more money available for distributions. And those distributions are largely tax deferred, with the possibility of being tax-free to one’s heirs given thoughtful estate planning.

Nonetheless, Antero concluded that the MLP structure no longer suited them. They joined a long list of companies who’ve reached the same conclusion, including Kinder Morgan (KMI), Targa Resources (TRGP), Semgroup (SEMG), Oneok (OKE), Archrock (AROC), Williams (WMB), Dominion (D) and Enbridge (ENB). Tallgrass (TGE) has retained the partnership structure for governance but chosen to be taxed as a corporation, and Plains All American offers a option for both 1099 (PAGP) and K-1 tolerant (PAA) investors.

They’ve all found that MLP investors are too few and fickle to be a reliable source of equity capital. Tax impediments add cost and complexity to tax-exempt and non-U.S. institutions, a substantial portion of the investor base for U.S. public equities. The K-1s are how investors achieve the tax benefits noted above, but their complexity dissuades most retail investors. Once you eliminate these different classes of investor, almost the only buyers left are taxable, high net worth individuals. In other words, older, wealthy Americans.

These investors like their income, and the several dozen distribution cuts imposed in recent years have done irreparable harm. The high payout ratios of MLPs left little cash for funding growth projects (see It’s the Distributions, Stupid!). This wasn’t a problem until the Shale Revolution created the need for investments in new infrastructure, to support the huge increases in U.S. oil and gas output. Cash was duly diverted from payouts to growth projects, leading to a 30% drop in distributions (see Will MLP Distribution Cuts Pay Off?).

EBITDA improved and leverage came down, but MLP investors only care about distributions, which were cut by 30%. Consequently, the sector fell hard and is still 30% below its 2014 peak.

MLP-dedicated funds are left with fewer, smaller fish to catch. Their promoters still defend them, in spite of their flawed structure rendering them taxable with correspondingly eye-watering expenses (see MLP Funds Made for Uncle Sam). As pipeline companies continue to abandon the MLP structure, it’s showing up in the sinking market cap of the MLP indices. The market cap of both the Alerian MLP Index (AMZ) and the Alerian MLP Infrastructure Index (AMZI) are decreasing even while the sector is up this year.

It’s stark evidence of the declining role MLPs play in U.S.energy infrastructure. Affected ETFs include those from Alerian (AMLP) and InfraCap (AMZA). Mutual funds from Oppenheimer Steelpath, Centercoast, Mainstay Cushing and Goldman Sachs are similarly stuck with a declining opportunity set.

These MLP-dedicated funds can’t easily change their structure to avoid taxes by becoming RIC-compliant – they’d have to sell 75% of their MLPs, which is prohibitively disruptive. Some smaller funds whose MLP sales weren’t market moving have done so, which shows that others would if they could. Instead, MLP fund proponents are left to argue that their fund structure is optimal, even though no new MLP-dedicated funds are being launched any more.

Some big MLPs are happy enough. Enterprise Products (EPD), Magellan Midstream (MMP) and Energy Transfer (ETE) are all sticking with the structure. It works best if you don’t need external financing. We are invested in all three companies through our funds and separately managed account strategies.

MLPs can still be good. An MLP-only approach is not. MLP-dedicated funds are the worst place to be, given the shrinking MLP market cap and tax burden. But broad energy infrastructure, growing as we pursue American Energy Independence, is cheap.

We are long AMGP, AROC, ENB, EPD, ETE, KMI, OKE, MMP, PAGP, SEMG, TGE, TRGP, WMB. We are short AMLP.

Ethane prices recently hit a four year high. Although this garnered far less attention than the crude oil rally, increasing supplies of ethane is an unappreciated element of the Shale Revolution.

“Dry” natural gas consists of methane, most commonly supplied to residential gas stoves but also increasingly used by power plants to produce electricity. “Wet” gas includes other natural gas liquids (NGLs), such as ethane (more below), propane (used in your outdoor BBQ), butane (cigarette lighters) and other more obscure NGLs such as isobutene. Typically, the NGLs and other impurities are separated out from the wet gas, leaving methane as the natural gas that flows to customers. Because NGLs have marketable value, wet gas is more desirable.

Ethane, once converted to ethylene through “cracking” is the principal input into production of polyethylene. Simply put, ethane is turned into plastic. Polyethylene is manufactured in greater quantities than any other compound.

The process is fascinating, and naturally the internet provides ample information. Ethane molecules are broken through heating (“cracked” in industry parlance), and the ethylene produced undergoes further processing into polyethylene pellets. These plastic pellets come with different properties such as strength, flexibility and melting point, which determine their ultimate use. They are heated and molded into many thousands of consumer and specialty products. For an absorbing description that follows ethane molecules from extraction to ultimate use, the Houston Chronicle’s three-part series Texas petrochemical plants turn ethane into building blocks of plastic is highly readable.

Among many fascinating steps, we learn that molten polyethylene pellets are blown into a very thin cylindrical balloon, several hundred feet long. This is then turned into sheets by passing through rollers, and multiple sheets are combined depending on the desired thickness. In the article, these ethane molecules ultimately traveled as plastic pellets to Vietnam where they were processed into packaging for frozen shrimp that was shipped back to the U.S. The petrochemical industry makes this happen.

U.S. ethane production has more than doubled in the past decade, to 1.5 Million Barrels per Day (MMB/D). Ethane is a gas and isn’t shipped in barrels. The MMB/D unit of measure converts the energy content of the ethane to that in a barrel of crude oil. Barrels of Oil Equivalent (BOE), allows volumes of most hydrocarbons to be measured using a common metric. What further sets the U.S. apart is that shale’s light crude comes with relatively high concentrations of NGLs, including ethane. It simply needs to be separated out.  The alternative source of ethane is as a by-product from refining crude oil, a more costly approach.

The U.S. is producing so much ethane that some of it is being mixed in with the methane natural gas stream as it can’t be profitably used elsewhere (known as “ethane rejection”). Low ethane prices with the promise of ongoing ample supply have led to a flurry of new petrochemical investments.  Cheap natural gas lowers processing costs, since the conversion of ethane to plastic pellets requires heat. For example, Exxon Mobil (XOM) operates one of the world’s largest polyethylene plants in Mont Belvieu, TX, with ethylene provided by a new facility at their nearby Baytown complex.

But the big increase in natural gas output is in Appalachia, where the Marcellus and Utica shale formations are providing most of this new supply. Royal Dutch Shell is building a new ethane cracker in western Pennsylvania, close to its supply. In total, $202BN of investments in 333 projects have been announced since 2010. U.S. ethane exports have been rising, but as these new facilities become operational they will increase domestic demand. Two thirds of the investments involve foreign companies. The recent jump in the ethane price is partly attributable to new domestic buyers.

The result is that ethane trade flows are shifting, and the U.S. is becoming a more important supplier of plastics.

The Shale Revolution draws attention for the growth in fossil fuels — crude oil and natural gas, where the U.S. leads the world.  But we’re even more dominant in NGLs, contributing one-third of global production. The impact of NGLs and consequent growth in America’s petrochemical industry receives far less attention, although it’s another huge success story.

Enterprise Products Partners (EPD), Energy Transfer Equity (ETE), Oneok Inc. (OKE) and Targa Resources Corp (TRGP) are well positioned to benefit from America’s growing NGL production. Our funds are invested in all of them.

Technical analysis shows that the outlook for pipeline stocks is bullish.

We rarely write on technicals, since we’re relentlessly focused on the fundamentals. But fundamental news has been light, with prices drifting irregularly lower. Investors are overwhelmingly frustrated with the failure of pipeline company stocks to reflect growing throughput volumes. The U.S. just claimed World’s Biggest Oil Producer (see America Seizes Oil Throne). Liquified Natural Gas exports are set to more than double next year (see U.S. Oil and Gas Exports: A New Weapon). In willful defiance, pipeline stocks sagged. One sell-side analyst described recent investor meetings as, “at times blurred between market discussions and therapy sessions.”

For a chartist relying on technical analysis, we think the sector is setting up for a sustained rally. We don’t make investment decisions based on charts. As a visual price history they are helpful, but our portfolio adjustments are driven by shifts in long term fundamentals. However, many investors use technical analysis as a timing aid. Some pore over charts carefully before making decisions. Absent much market-moving news, such analysis is more relevant.

Energy infrastructure charts show three bullish patterns. The first is that the sequence of lower lows from late last year into Spring was not confirmed by the Relative Strength Index (RSI) readings. This type of divergence typically indicates weaker conviction among sellers on each successive dip, warning of a change in trend. Sure enough, the recent August high exceeded the prior one in February, revealing that a new uptrend has begun.

Supporting this, in June the 50 day moving average convincingly crossed the 200 day moving average, following which the sector moved smartly higher.

Further confirmation is provided by the clear upturn in the 200 day moving average.

This all points to a sector in which medium term (i.e. 3-12 months) momentum is turning up, with the recent softness not that material over a longer perspective. Crude oil technical analysis shows a bull market many months old, adding to the frustration of  investors in pipeline stocks who feel the two are only correlated on the downside.

Nonetheless, the sector has been weak. It might be in part because the Alerian MLP ETF (AMLP) has experienced steady outflows since June. Its shares outstanding have dropped by 8% in spite of the fact that 2Q18 earnings were generally good. Some of this is probably due to growing awareness of its flawed tax structure (see Uncle Sam Helps You Short AMLP) and shrinking pool of MLPs (see The Uncertain Future of MLP-Dedicated Funds). One reader on Seeking Alpha described it as “obsolete and tax inefficient”.

Oil and gas volumes continue to grow, which augurs well for the next earnings reports in October. Examples of infrastructure shortages abound. Natural gas at the Waha hub in west Texas trades at $0.82 per thousand cubic feet, a steep discount to the $3 Henry Hub benchmark because gas production exceeds pipeline capacity. Gas is being flared in the Permian basin.

Crude oil in Midland, TX trades at a $12 per barrel discount to Cushing, OK (the delivery point for CME futures). This similarly reflects a shortage of pipeline capacity, since tariffs on long term contracts are around $3-$5. The 2015 collapse was due to fears of pipeline overcapacity, so today’s bottlenecks ought to be positive.

Proposition 112 is the Colorado referendum question that would greatly impede future oil and gas development.  Fear of it passing in November has weighed on affected stocks, such as Noble Midstream (NBLX) and Western Gas (WES). But there’s no indication that other states are considering similar moves, so its impact is limited to those with significant Colorado exposure.

We expect solid 3Q18 earnings, which will support 10% dividend growth across the sector.  This might well provide the fundamental impetus needed for pipeline stocks to rally. When that happens, technical analysts can point to chart patterns that predicted it.

We are invested in Western Gas Equity Partners (General Partner of WES), and are short AMLP.