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Deja Vu All Over Again for Pipelines?

Years ago, before the Shale Revolution became the phenomenon it is, comparisons were often made between MLPs and REITs. Both offered attractive yields from real assets, and income-seeking investors were drawn to them.

As a result, their performance tracked each other pretty closely. Investors focused on the relative value of one versus another generally kept them in line. This was the period when pipelines earned their reputation as “toll-models”, driven by volumes with little relationship to crude oil.

REITS and Pipelines Move Together

Long-time investors in energy infrastructure fondly remember those days and many retain mixed feelings about America’s resurgence in oil and gas production. MLPs embraced growth projects, and payouts to investors soon suffered.

It’s worth recalling the pre-2014 era, because pipeline stocks are resuming dividend growth once again. The growing realization has already led to a strong start to 2019, with the sector up almost 20%. Comparisons with REITs or utilities made little sense for investors seeking income when MLP income was uncertain. The 36% drop in payouts from the Alerian MLP ETF (AMLP) reflect a big betrayal, but not a collapse in the business. Nonetheless, as we’ve often found when talking to investors, distribution cuts for any reason tend to drive them away.

Enterprise Products (EPD) CEO Jim Teague reflected the mood when he recently said, “So many of these guys cut their distributions. I wouldn’t buy their stock either.” Reliable payouts matter.

Since 2014 MLPs and REITs have maintained a loose relationship, and although the economic link between crude oil and pipeline company profits is generally weak, at times they have been manacled together. Some investors will ruefully add that the link is strongest when crude oil is falling.

REITS and Pipelines Part Ways

Rising pipeline distributions reflect an acknowledgment of investors’ requirement for greater capital discipline with predictable payouts. Growth capex for the industry was $55BN last year and looks likely to be lower this year, freeing up cash. Several big projects are nearing completion, which will further support cashflows.

Internally funded growth is the new normal. The older, wealthy Americans who are the main direct investors in MLPs have demonstrated resoundingly that they don’t want to finance growth. It’s why there were no MLP IPOs last year. Leverage is down to 4X Debt:EBITDA.

Energy infrastructure stocks offer compelling value versus REITs. Distributable Cash Flow (DCF) yields of 10-11% are growing 10% annually in the broad-based American Energy Independence Index (this is 80% corporations and 20% MLPs). REITs offer yields from Funds From Operations (cash generated from existing assets before growth capex, similar to pipeline companies’ DCF) of around 6% with little growth.

DCF Yields REIT vs AEITR

Income stability should draw more REIT investors to consider pipelines, which will restore the close relationship the two sectors shared for many years. This in turn will further weaken the link to crude oil.

MLP Yield Spread vs. REITS

The energy sector’s collapse in 2014-16 caused MLPs to fall more than they did during the 2008-9 financial crisis. Memories of that episode remain fresh, but many signs suggest that the stability of earlier years is returning.

Join us on Thursday, March 21st at 1pm EST for a webinar. We’ll review the prospects for continuing growth in US oil and gas production. To register please click here.

We are invested in EPD and 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)

Pipelines’ New Look

The point of a public equity listing is to be able to access public markets for financing, to use the stock as a currency for acquisitions, and to provide liquidity for investors. A company’s cost of equity moves inversely with its stock price, just like bond yields and prices. Access to cheap equity is vital for companies that have growth projects, including most energy infrastructure companies. MLPs continue to face a comparatively high cost of equity.

It’s one of the reasons why we believe over the past few years many of the biggest MLPs have “simplified”, which has often meant they’ve abandoned the MLP structure to become a regular corporation (a “c-corp”). An important objective behind each of these restructurings has been to lower their cost of equity. Kinder Morgan (KMI) led this move in 2014, when their desire for external capital to fund their backlog of growth projects collided with the interests of their income-seeking holders. Investors in Kinder Morgan Partners (KMP) weren’t much interested in plowing their distributions back into secondary offerings, so KMP’s yield rose to levels that made equity issuance uneconomic (see 2018 Lessons From The Pipeline Sector).

KMI decided to combine with KMP, creating unexpected tax bills for holders and leading (eventually) to two distribution cuts. The goal was to access a broader set of investors. Fewer than 10% of the money allocated to U.S. equities can invest in MLPs. Taxes and K-1s generally limit buyers to U.S. high net worth individuals. KMI wanted to reach U.S. pension funds, global sovereign wealth funds, and other significant buyers. They had outgrown the old, rich Americans, who used to own their stock. If you ever talk to a former KMP investor, you’ll learn how much bitterness this caused (see Kinder Morgan: Still Paying for Broken Promises).

Other MLPs followed, and today midstream energy infrastructure is more corporations than MLPs. The list includes Enbridge (ENB), Oneok (OKE), Pembina (PBA), Targa Resources (TRGP), Semgroup (SEMG), Transcanada (TRP) and Williams (WMB). None of these are in an MLP index.

In late 2017 we created the investable American Energy Independence Index (AEITR). It’s a market-cap weighted index of North American energy infrastructure companies. It includes some MLPs, because the structure still works for those not in need of external equity. But MLPs are kept at 20%, reflecting their diminished role.

The AEITR’s limit on MLPs also means that funds linked to it aren’t subject to corporate tax. A flawed tax structure has been a substantial drag on performance for MLP-dedicated funds. For example, the Alerian MLP ETF (AMLP) has a since inception return of 0.47% p.a., compared with its index of 2.75%. It’s delivered less than a fifth of its index since 2010, in part because of a structure that requires it to pay corporate tax. Nobody would create such a fund today.

See MLP Funds Made for Uncle Sam for more detail.

AMLP's Tax Burdened Performance

The Alerian MLP indices are becoming outdated, because they represent what the pipeline business used to be, before MLPs started converting to corporations. An MLP-only approach to energy infrastructure misses most of the sector. MLPs aren’t going away, they’re just becoming less important.

For the former MLPs who converted so as to lower their cost of capital, stock performance shows that these were good decisions. The AEITR’s 80% allocation to corporations makes it more representative than the Alerian MLP Index (AMZX). Performance differences between the two are driven by how corporations are doing relative to MLPs. This year, AEITR is 5% ahead.

Pipeline Corporations Outperform MLPs

What’s also encouraging is that it’s coming with lower volatility. Since AEITR’s creation in October 2017, it has had average daily moves of 1.5%, half that of AMZX. This makes sense, because the corporations that make up 80% of AEITR have a wider pool of investors. It’s precisely why MLPs have been converting. A more diverse set of buyers means a deeper market, which lowers the risk for investors and thereby lowers the cost of capital for those companies.

Corporations Are Less Risky vs MLPs

So far, we haven’t heard of a company that regrets its decision to drop the MLP structure in a simplification, and those that remain get questions on every earnings call about their possible plans to simplify. There are some well run, attractive MLPs, including Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), Energy Transfer LP (ET), Western Gas Partners (WES), and Crestwood Equity Partners (CEQP). But the evidence is mounting that the adoption of a corporate structure and the global investor base that comes with it is beneficial.

We are invested in ENB, EPD, ET, KMI, MMP, OKE, PBA, SEMG, TRGP, TRP, WMB.

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)

4Q18 Energy Infrastructure Earnings Wrap Up

Earnings season often produces memorable soundbites during the conference calls that follow. Last summer, Energy Transfer (ET) CEO Kelcy Warren said, “A monkey could make money in this business right now.” (see Running Pipelines is Easy). Kelcy is not overly burdened with modesty, but at least he is backing up his brash comments with results. ET’s 4Q18 report completed a strong year, and they reaffirmed previous 2019 guidance that is at the high end of expectations. ET is seeing the benefits of its exposure to Permian crude oil, natural gas and NGL logistics.

The company has an aggressive culture, which is reflected in their laudable response to troublesome environmental activists. But it also shows up in conflict with regulators in Pennsylvania, where all work was recently halted on its Revolution pipeline project due to compliance failures. When asked what lessons they’ve learned, Kelcy answered “We’ve learned a lot. Every place is not Texas.” There’s also the ill-fated pursuit of Williams Companies (WMB), which included a dubious issuance of convertible stock to management (see Will Energy Transfer Act with Integrity?, written when we thought they might). ET’s management has a checkered reputation.

Nonetheless, with a Distributable Cash Flow (DCF) yield of 14.7%, this is a cheap stock. If not for the preceding considerations it would be a bigger position for us.

TRGP 4Q18 Earnings

Joe Bob Perkins, CEO of Targa Resources (TRGP), provided this quarter’s memorable quote. Responding to a question about increased 2019 growth capex, he responded, “…I described it as capital blessings”.

One reason why S&P Energy has been the weakest sector for four of the past five years is the differing views on capital allocation between management and investors. Companies want to invest to grow, while investors would prefer greater return of cash, through buybacks and dividend hikes. Joe Bob knows what investors want whether they like it or not. He continued, “Those are high return strategic investments that every investor looking under the covers would want us to make. And I think most investors and analysts like you looking from the outside in, knowing what they are and when they’re coming on, wanted us to make those investments.”

Joe Bob Perkins gives the impression of tolerating his investors rather than treating them as owners. You’d think having missed selling the company at $140 per share five years ago to ET, he’d have a little more humility.

You could almost hear the TRGP Investor Relations folk wincing. The 13% subsequent drop in TRGP more than offset the bounce earlier in the week from the attractive sale of 45% of their Badlands project to Blackstone Group.

Plains All American (PAGP) saw a welcome rebound in its Supply & Logistics (S&L) segment. MLPs are often described as possessing a “toll-taking” business model that implies stability. S&L is all about exploiting basis differentials – when the price of crude oil between two different points differs by more than the tariff of the available pipeline, PAGP’s network allows it to extract additional profits that are a form of arbitrage. It is a measure of tightness in pipeline availability. In 2013 S&L generated $822MM in EBITDA.

Like other midstream companies, Plains expanded its asset base as the Shale Revolution pushed volumes higher. S&L is a volatile business, and its collapse in 2017 to $60MM in EBITDA coincided with PAGP’s increasing debt, raising leverage and leading to distribution cuts. In general, reduced payouts across the industry coincided with rising EBITDA. But in PAGP’s case they erred by relying too much on a part of their business that relies on market inefficiencies, and doesn’t provide the recurring revenues of pipelines and storage facilities.

Income-seeking investors endured two distribution cuts. The first cut came when the company simplified its structure by waiving the incentive distribution rights PAGP held in its MLP, Plains All American (PAA). A year later, and after an expensive Permian acquisition, it was cut again. Today, both securities offer identical exposure. PAGP provides a 1099 for investors who want simplicity, and PAA a K-1 for greater tax deferral with a little more complexity. By design the two stocks track each other closely.

PAA’s Leverage is now down sharply. 2019 growth capex is expected to be $1.1BN, down from $1.9BN in 2018. The Distributable Cash Flow (DCF) yield is 10.6%, and is expected to grow 6-7% this year.

The prior week WMB reported full year DCF of $2.872BN, up 11% on 2017, as natural gas volumes surged. On the earnings call they noted Transco reached a one day record of 15.68 million dekatherms on January 21 (around 15% of nationwide consumption), when temperatures plummeted across much of the U.S.

Overall, energy infrastructure earnings were mostly good news. We continue to expect increasing dividends this year to draw additional investors to the sector.

We are invested in ET, PAGP, TRGP, 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)

REITS: Pipeline Dividends Got You Beat

Long time MLP investors fondly recall the days before the Shale Revolution, when yield comparisons with REITs and Utilities made sense. This ended in 2014, when the energy sector peaked. Cumulative distribution cuts of 34%, as subsequently experienced by investors in the Alerian MLP ETF (AMLP), convinced income seeking investors that pipelines were a hostile environment.

During the 2014-16 collapse in crude oil, yield spreads on energy infrastructure blew out compared with sectors that were formerly peers. It might be the only period in history when companies have slashed distributions primarily to fund growth opportunities, and not because of an operating slump (see It’s the Distributions, Stupid!)

EBITDA vs Leverage

Several months ago, Bank of America published this chart showing that EBITDA for the sector grew steadily through the energy collapse, and leverage came down. Persistent weakness in the sector can best be explained by the betrayal of income-seeking investors. Distribution cuts were unacceptable to many, regardless of the reasons.

2019 should be the first year since crude oil bottomed at $26 per barrel that payouts will be rising (see Pipeline Dividends Are Heading Up). Because falling distributions are so clearly the reason the sector has remained out of favor, increasing payouts could provide the catalyst that will drive a strong recovery.

Income-seeking investors who return to the pipeline sector will find much to like. Funds From Operations (FFO) is a commonly used metric for REITs. It measures the net cash return from existing assets. The analogous figure for energy infrastructure businesses is Distributable Cash Flow (DCF).

We’ve found that comparing pipelines with real estate resonates with many readers. Differentiating between cash earned from existing assets and cash left over after investing in new assets is intuitive when applied to an owner of buildings.

As we showed in Valuing Pipelines like Real Estate, looking at Free Cash Flow (FCF), or net cash generated after new initiatives, doesn’t present an accurate picture if a company is investing heavily. And because dividends have been declining, it’s been hard for investors to get comfortable that current payouts are secure. Since neither FCF nor dividend yields have been enticing, capital has often avoided the sector.

MLPs commonly paid out 90% or more of their DCF in distributions, which left too little cash to fund the growth projects brought on by the Shale Revolution. Attractive DCF yields drew scant attention when payouts were declining, but a consequence of the sector’s loss of favor is that 2019 DCF yields are two thirds higher than for REITs.

DCF Yields REIT vs AEITR

Moreover, they’re set to grow faster. U.S. REIT investors can expect only 2% growth in FFO on a market-cap weighted basis (data from FactSet). We expect 2020 DCF for the American Energy Independence Index to jump by 10.3%. Improving cash flow supports rising dividends, which we expect will be up 10% this year and next (see Income Investors Should Return to Pipelines in 2019).

Much of this is the result of growth projects being placed into production. A pipeline doesn’t generate any cash until it’s completed, so virtually all the expenditure occurs up front. MLP investors suffered the distribution cuts necessary to help fund this – we’re now starting to see the uplift to cashflows. It’s further helped by a likely peak in growth expenditures (see Buybacks: Why Pipeline Companies Should Invest in Themselves, chart #4).

MLP Yield Spread vs. REITS

Once REIT investors return to comparing their holdings with energy infrastructure, they’re going to find strong arguments in favor of switching. They’ll find they can upgrade both their income and growth prospects by moving their REIT holdings into pipelines. MLP yields are historically wide compared with REITs, and 85% of the last decade the relationship has been tighter. Just remember to invest in broad energy infrastructure and not to limit your investment to MLPs (see The Uncertain Future of MLP-Dedicated Funds). Four of the five biggest pipeline companies are corporations, not MLPs, which nowadays represent less than half the sector.

Top 5 Holdings REITs vs Pipelines

The Shale Revolution is a fantastic American success story. The Energy Information Administration expects U.S. crude oil output to reach 13 million barrels per day (MMB/D) next year. The U.S. continues to gain market share. It’s estimated that Saudi Arabia needs a price of at least $80 per barrel to finance their government spending. To this end, the Saudis are cutting production to below 10 MMB/D. They’re slowly ceding market share in the interests of higher revenues.

Investors have little to show for allocating capital towards the Shale Revolution. That is about to change. The American Energy Independence Index is up 18% so far this year, easily beating the S&P500 which is up 10%. The sector is starting to feel the love.

Join us on Friday, February 22nd at 2pm EST for a webinar. We’ll be discussing the outlook for U.S. energy infrastructure. The sector has frustrated investors for the past two years, but there are reasons to believe improved returns are ahead. We’ll explain why. To register please click here.

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)

American Energy Independence is Imminent

The U.S. Energy Information Administration (EIA) recently published their 2019 Annual Energy Outlook. Whenever your optimism on the prospects for U.S. energy infrastructure waivers, this will restore your confidence. The outlook for domestic energy production is bullish, and in many cases more so than a year ago.

For example, in their 2018 report, the EIA’s Reference Case projected that the U.S. would eventually become a net energy exporter. Now, thanks to stronger crude and liquids production, they expect that milestone to be reached next year.

EIA Annual Energy Forecast 2018 vs 2019

The expected improvement in America’s balance of trade in liquids is dramatic, especially compared with last year’s report. It’s equivalent to an additional 2.5-3.0 Million Barrels per Day (MMB/D) of output.

EIA Net Energy Trade 2018 vs 2019
EIA LNG Projections

Liquified Natural Gas (LNG) exports are also set to jump sharply, and overall natural gas exports are projected to more than double over the next decade. This is driven by growing Permian crude output, which comes with natural gas as an associated product from oil wells. It’s why flaring is common today, because the needed takeaway infrastructure for natural gas remains insufficient. Mexico’s own infrastructure to import natural gas for electricity generation is still being developed, and new LNG export facilities will provide further demand.

The middle chart in the panel below highlights the correlation of natural gas output with the price of crude oil. This is because the EIA assumes that higher crude prices will stimulate more Permian oil production, producing more associated natural gas.

EIA Associated Natural Gas Production

Although use of renewables to generate electricity will grow, they’re still expected to provide less than one third of all electricity even in 30 years. Almost all the growth will be in solar, which works best in southern states that receive more sun. Although my state, New Jersey, is subsidizing residential solar roof panels, they’re not much use in winter. This is especially so because electricity demand generally peaks twice a day, around breakfast and dinner, when people are leaving for work/school or returning home. At this time of year in the northeast, it’s dark during both peak periods. Only half the days are even partly sunny, with cloud cover rendering solar ineffective on the rest.

Moreover, the bucolic, leafy suburbs enjoy plenty of summer shade which can also block the sun from reaching solar panels. Widespread deployment of solar will require cutting down some big old trees that impede southern exposure.

EIA Renewables Growth

Large-scale battery technology doesn’t exist to store midday solar power for use at peak times Therefore, intermittent sources of power (also including wind) require substantial excess capacity, as well as baseload power that’s always available. Environmental activists haven’t all accepted this yet, but natural gas remains the big enabler for increased solar power.

Some extremists desire a carbon-free world, but that Utopian objective ignores the symbiotic relationship natural gas and solar/wind share. They’re complimentary energy sources. Opposing all fossil fuels impedes the growth of intermittent energy sources and forces more excess, redundant capacity. The Sierra Club and those who share their views seek impractical, purist solutions that will struggle both economically and politically.

Intermittent Solar Needs More Natural Gas

Natural gas is in many ways a bigger U.S. success story than crude oil. Its abundance ensures continues low prices, supporting both exports as well as cheaper domestic electricity than most OECD nations. Because the U.S. has some of the lowest-priced natural gas, different scenarios nonetheless offer fairly uniform growth in output. Natural gas prices are less susceptible to the cycles of crude oil, which combined with America’s advantages noted above makes investing in its infrastructure more attractive.

EIA Steady Rise in Natural Gas Production

There’s plenty in the EIA’s 2019 Outlook to support a bullish view for midstream energy infrastructure. Financing growth projects has weighed on stock prices for several years, leaving investors frustrated and complaining about insufficient cash returns. But if the peak in growth capex peak is behind us, as looks likely, free cash flow and payouts should start increasing again. Cash flow yields on the sector average 12% before growth capex. This is analogous to the funds from operations metric used in real estate, but double the yield on the Vanguard Real Estate ETF (VNQ), for example. REIT investors should take note.

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).

MLP-Dedicated Funds See Increasing Redemptions

Fund flows will always beat fundamentals. This was rarely more evident than in the performance of MLPs last year. Throughout 2018, earnings reports from pipeline companies were generally in-line, with positive guidance. Operating results contrasted with stock prices, which confounded investors and management teams as they sagged. Negative sentiment worsened late in the year, not helped by broader market weakness caused by trade friction, Fed communication mis-steps and the Federal government shutdown.

JPMorgan calculates that there is $38BN invested in open-ended MLP and energy infrastructure products, across ETFs, mutual funds and exchange traded notes. In spite of peaking in August 2014, the sector saw inflows during the three subsequent years. This reversed dramatically late last year, as retail investors liquidated holdings. November and December saw $1.9BN in net outflows, enough to depress prices regardless of news.

Energy Infrastructure 5 Years of Inflows
Energy Infrastructure Q418 Fund Outflows

Looking back over several years, the period looks like a selling climax, with no similar episodes visible.

Conversations with redeeming investors revealed many unwilling sellers. Taking tax losses motivated some, while others confessed to exhaustion with poor stock returns in spite of apparently improving fundamentals. Like all money managers in the sector, we were faced with little choice but to sell on behalf of such clients.

Interestingly, MLP-dedicated funds received a disproportionate share of redemptions. This makes sense, given their flawed tax structure (see MLP Funds Made for Uncle Sam). The drag from paying corporate taxes on profits has been substantial in past years of good performance.

MLP Dedicated Fund Outflows

Hinds Howard of CBRE Clarion Securities recently noted that, “MLPs are less than half of the market cap of North American Midstream, and the number of MLPs continues to shrink.  This is ultimately a good thing for those public players that remain, who will achieve greater scale and competitive bargaining power.” Many big pipeline operators are corporations, so an MLP-only focus makes less sense because it omits many of the biggest operators.

Howard went on to add that, “…it has significant ramifications for the asset managers with funds designed specifically to invest in MLPs.” This is because such funds are faced with an unenviable choice between sticking with a shrinking portion of the overall energy infrastructure sector, or dumping most of their MLPs in order to convert to a RIC-compliant status (see The Uncertain Future of MLP-Dedicated Funds). These are additional marketing headwinds on top of last year’s weak returns.

2018 fund flows suggest that investors in MLP-only funds are beginning to realize this problem, and are acting accordingly. The biggest such funds saw $2.6BN in net outflows during 2018’s latter half, 88% of the total, although they only represent 55% of the sector’s funds. Investors redeemed from tax-burdened MLP funds at almost twice the rate of the overall sector.

Many feel the sector is due a good year, and if it is, corporate taxes will lead to correspondingly high expense ratios for MLP-focused funds.

Energy Infrastructure Open Ended Fund Flows

Early signs in 2019 are encouraging. The outflows abruptly ended at year-end, and investors we talk to are turning more positive. Strong January performance has helped. From where we sit, inflows dominate and new investor interest has increased sharply. Valuations remain very attractive, with distributable cash flow yields of 11%. We expect dividend growth in the American Energy Independence Index of 7-10% this year and next. Momentum seems to be turning.

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).

Kinder Morgan: Great, But Stick to Pipelines

Kinder Morgan (KMI) kicked off pipeline company earnings last week. Their results contained no big surprises. Distributable Cash Flow (DCF) for the year came in at $4.73BN, up 5.5% versus 2017’s $4.48BN. Leverage finished the year at 4.5X (Net Debt/Adjusted EBITDA). KMI has argued previously that their diversified business could sustain a 5.0X ratio, something not always supported by the rating agencies. The sale of their TransMountain pipeline to the Canadian government (see Canada’s Failing Energy Strategy) created a cash windfall that they used to pay down debt. KMI now expects to remain at 4.5X for this year.

Like many investors, we think KMI’s continued investment in its CO2 business is a drag on value. Because Enhanced Oil Recovery (EOR) doesn’t generate the same recurring revenues as pipelines and terminals, we think the market assigns little value to the approximately 10% of DCF this segment represents. Moreover, the $1.6BN in capex planned for CO2 is 28% of the total backlog and three times what the company spent buying back stock in 2018. The commodity sensitivity of this segment is an unwanted distraction. If they can’t sell it, they should at least reduce the new cash deployed there.

Using a real estate analogy — if building and running pipelines is like constructing and owning rental property, then EOR is more akin to building houses and flipping them. For flippers, what matters is the net profit and not proceeds from each sale. Rental income (i.e. pipeline tariffs) are stable; profit from building and selling properties (i.e. oil production) is not. So DCF is the wrong valuation metric for the CO2 business, and basing a dividend on such unpredictable cash flows is inappropriate.  Midstream investors are not fooled by this, which we believe explains KMI’s persistent low valuation.

The uncertain recurring nature of the CO2 business causes many to overlook it. This lowers the DCF yield by about 1/10th to 11.2%, which is nonetheless still very attractive.  Considering KMI’s incredible position in natural gas pipelines, the market is applying a hefty discount.  When asked, management typically responds that selling its CO2 business would be dilutive, because in a sale it would command a lower EV/EBITDA multiple than KMI as a whole. But we think the company’s valuation remains burdened by a business segment that doesn’t obviously belong there. We were happy to see reports late on Thursday that KMI was exploring its possible disposition.

Putting that aside, we still think KMI is cheap. DCF is analogous to Funds From Operations (FFO), a common metric used in real estate and one we discussed in a video last year (see Valuing Pipelines Like Real Estate). It’s the cash generated from their existing business before growth projects. KMI is forecasting $5BN, or $2.20 per share in DCF for 2019, which is a 12.5% yield (11.2% ex the CO2 segment). However, they’re planning to invest $3.1BN in new projects during the year, and since this will be funded internally their Free Cash Flow (FCF) will be lower by this amount.

KMI’s $0.80 annual dividend is expected to rise to $1, a 5.7% yield. The company has projected another increase in 2020, to $1.25. Yield-seeking buyers will increasingly take note.

KMI Payouts

They will need to forgive the past. Prior to 2014, KMI and its former MLP Kinder Morgan Partners (KMP) were owned for income. The conflict between a high payout ratio and ambitious growth plans resulted in the absorption of KMP’s assets by KMI. In the process, KMP units were each replaced with 2.2264 KMI shares. KMI’s $2 dividend worked out to be $4.45 per KMP unit, 20% less than the $5.58 they were receiving previously.  There was a cash payment of $9.54, but KMP unitholders also suffered that infamous adverse tax outcome, which many regarded as more costly.

Moreover, the $2 KMI dividend, which was promised to grow at 10% annually, was instead slashed by 75% a year later.  For many companies, such a dramatic reversal would reflect poorly on the finance function and result in management changes. However, KMI’s CFO Kimberly Dang was subsequently promoted to president. Sell-side analysts won’t highlight this for fear of losing access, but that track record isn’t a positive for the stock. Regrettably for the company’s founder, being “Kindered” is now a widely used term when your promised distributions lose out to a company’s growth plans.

The Shale Revolution continues to be a fantastic success story for America, but increasing oil and gas production requires new infrastructure to gather, process, transport and store it. Like many companies afterwards, KMI ultimately chose to direct more cash towards growth projects and correspondingly less to shareholders.

Therefore, the drop in growth capex is a critical development. Five years ago as midstream energy infrastructure embraced a growth business model, it soon became clear this was incompatible with high payout ratios, and the income-seeking investors they had sought. We are now coming down the other side of the capex mountain, which is supporting a resumption of dividend growth. For KMI investors it’s been an unpleasant journey, but a DCF, or FFO yield of around 11% (after backing out the CO2 business) is substantially greater than REITs, a sector with which MLPs used to be compared.

In 2014 KMI had a five year backlog of $18BN in projects under way, which was financed in part by the reduced dividends. Today they expect $2-3BN in annual growth capex, and have $5.7BN in projects at various stages of completion.

KMI’s rising dividend should support growing realization that energy infrastructure stocks are returning more money to shareholders. Its yield is rising to a level that should attract new income-seeking investors willing to forgive past mistakes by management.

We are invested in KMI.

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).

Lose Money Fast with Levered ETFs

A few years ago Vanguard invited me to their campus to give a presentation on my just-published book, The Hedge Fund Mirage. Vanguard’s business model is the antithesis of the hedge fund industry, and they were curious to hear from that rare breed, a hedge fund critic. The company’s frugal culture runs deep. As I joked during my presentation, the only German car in the parking lot was mine. Lunch was in the “galley” (cafeteria), where my host reached into his pocket to buy my sandwich and fruit cup. This is a company whose products are usually appropriate ways to access a desired asset class.

So it was in character for Vanguard to recently ban leveraged and inverse ETFs from their brokerage platform. Such products have long been criticized because their only plausible use is for extremely brief holding periods of a few days or less. Because of their daily rebalancing, over time compounding drives their value to zero. To visualize this, imagine if you owned a security which rebalanced its risk daily so as to maintain constant market exposure. A 10% down move followed by a 10% up move would leave you down 1%. Time and volatility work against the holder, except for those able to successfully predict the daily fluctuations and time their trades accordingly. Only those seeking profits in a hurry, or trying to temporarily hedge more risk than they’d like, find them attractive. Neither resembles a long-term investor.

Vanguard’s philosophy prevents creating leveraged or inverse ETFs of their own, but now they’ve taken a logical further step to increase the distance between their clients and long term value-destroyers. They correctly noted that such products are, “generally incompatible with a buy-and-hold strategy.”

This is a popular area, with soaring volumes in recent years. It’s another example of the excessive focus on short term market direction. Consumers of financial news want to know where the market’s going today, and media outlets duly respond. But prospectuses routinely warn that leveraged ETFs will probably decline to zero over time, which means the average holder will lose money. On this basis, one might think the SEC would find banning them easily defensible. So far, while individual commissioners have voiced concern, they haven’t moved further. Finance is not short of regulation, and a philosophy that allows consumers to decide appropriateness for themselves allows innovation, and is more right than wrong. However, it works best when the products financial companies offer to their least sophisticated, retail clients are designed with good intentions. Hedge funds and other sophisticated investors can be expected to properly understand how to use leveraged and inverse ETFs – like prescription medication, their availability should be carefully controlled.

We’ve been critics of these products for years (see Are Leveraged ETFs a Legitimate Investment? from 2014 as well as The Folly of Leveraged ETFs and recently FANG Goes Bang).

Leveraged ETF AMJL vs AMZX

In May 2016 Credit Suisse issued a 2X Leveraged ETN linked to the Alerian index. Since then it’s down 55%, while the index is down 12% (including distributions).  Losses are only limited to two times the index over very short periods. This type of long term result is common. It’s unrelated to the index and invariably worse, which Credit Suisse, and Alerian (who allowed their index to be licensed) would have known at the outset. Either name attached to an investment should give the buyer pause. It’s why these products shouldn’t be offered to retail investors.

Energy infrastructure remains one of the most attractively valued sectors around. The American Energy Independence Index yields 6.75%, and we expect dividends to grow 6-7% this year. This is attractive enough for the long-term investor, and isn’t available as a leveraged product.

On Wednesday, January 16th at 1pm Eastern we’ll be hosting a conference call with clients. If you’re interested in joining, please contact your Catalyst wholesaler, or send an e-mail to SL@SL-Advisors.com.

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).

Are Computers Exploiting MLP Investors?

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.

Energy Infrastructure Sometimes In Step with Crude Oil

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).

2018 Lessons From The Pipeline Sector

Blog pageviews and comments help us gauge how relevant our topics are. Writing is more enjoyable when readers engage. This blog gets reposted across many websites, including Seeking Alpha and Forbes.com. The feedback from subscribers often leads to a useful dialog and informs later choice of topics. Below are the themes that resonated in 2018.

The name Rich Kinder strikes a raw nerve with many. Kinder Morgan: Still Paying For Broken Promises revealed the depth of feeling among many investors. This is because Kinder Morgan (KMI) began the trend towards “simplification”, which came to mean distribution cuts and an adverse tax outcome. To get a sense of the betrayal felt by some, peruse the comments on the blog post on Seeking Alpha where readers can let rip in a mostly un-moderated forum. It becomes clear that cutting payouts has severely damaged appetite for the sector, something we realized through this type of feedback.

KMI Promises Made Promises Kept

A similar post examined how Energy Transfer (ET) had lowered payouts for certain classes of investor, (see Energy Transfer: Cutting Your Payout Not Mine) and drew an even bigger response (272 comments). ET CEO Kelcy Warren is a controversial figure. Our post showed that while original Energy Transfer Equity investors had avoided distribution cuts, holders of Energy Transfer Partners, Sunoco Logistics and Regency Partners hadn’t fared so well.

ETEs Distributions Climb While its Affiliate MLPs Decline

Kelcy Warren inspired our most colorful graphic in August, when he said, “A monkey could make money in this business right now.” (see Running Pipelines Is Easy). ET’s stock has lost a quarter of its value since then, even though their financial performance has justified his comments.

Last year was a testing one for those convinced the Shale Revolution should generate investment profits. In Valuing MLPs Privately; Enterprise Products Partners we laid out how a private equity investor might value the biggest publicly traded MLP. It wasn’t controversial, but many readers communicated their appreciation at this type of analysis.

The problem for the sector has always been balancing high cash distributions with financing growth projects. We think current valuations focus too much on Free Cash Flow (FCF) without giving credit to Distributable Cash Flow (DCF). FCF is after growth capex, while DCF is before. We illustrated this with a short video (see Valuing Pipelines Like Real Estate).

Early in the year we wrote several blog posts highlighting the tax drag faced by most MLP-dedicated funds. Because they pay Federal corporate taxes on investment profits, 2018’s bear market didn’t expose their flawed structure the way a bull market will. We won’t repeat the argument here, but it’s laid out in MLP Funds Made for Uncle Sam.

A related topic we covered several times was the conundrum facing MLP-only funds, given that many big MLPs have converted to regular corporations. MLP-only funds can no longer claim to provide broad sector exposure, since they omit most of the biggest North American pipeline companies. But the funds themselves can’t easily broaden their holdings beyond MLPs, which creates some uncertainty for their investors. We explained why in Are MLPs Going Away? and The Alerian Problem.

We returned to the tension between using cash for growth versus distributions in Buybacks: Why Pipeline Companies Should Invest in Themselves. The industry continues to reinvest more cash in new infrastructure than is justified by stock prices. In many cases, share repurchases offer a better and more certain return than a new pipeline. Trade journals are full of breathless commentary on the need for more export facilities, more pipelines, more everything. It’s not pleasant reading for an investor, but this is the world inhabited by industry executives. More mention of IRR would be welcome. Pipeline investors are hoping that the Wells Fargo chart showing lower capex in the future will, finally, be accurate.

Midstream Industry Forecasts Peak in CAPEX

Fortunately, there are signs of better financial discipline. Leverage continues to drop and dividend coverage is improving, which will support a 6-8% increase in dividends on the American Energy Independence Index in 2019. As the year unfolds, we expect investors to cheer a long overdue improvement in returns.

We are invested in ET and KMI.

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).

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