Archive for category: MLPs

Could the Shale Revolution be driving oil prices higher? It seems counter-intuitive – the U.S. is on course to be the world’s biggest oil producer by next year. And it was the additional shale supply that led to the 2014-15 oil collapse.

Yet, a growing chorus of industry voices is warning of an impending supply squeeze. This includes the Saudi Energy Minister, Khalid A. Al-Falih, who recently expressed concern about shortages of spare crude oil capacity. Last week David Demshur, CEO of oilfield services company Core Laboratories (CLB) forecast oil at $100 a barrel. He cited declining output in many key conventional plays globally, even while U.S. output is growing strongly. The International Energy Agency added their warning that, “…the world’s spare capacity cushion…might be stretched to the limit.”

Part of the problem relates to supply disruptions. Venezuela’s output continues to plummet because of chronic underinvestment. Renewed sanctions on Iran are impeding their exports sooner than expected. Saudi Arabia has promised to increase output to offset the loss of Iranian crude, but many question their ability to sustain output much above 11 Million Barrels a Day (MMB/D).

Meanwhile, global oil demand is expected to grow at around 1.5-1.7 MMB/D over the next year. Depletion of existing fields, estimated at 3-4 MMB/D annually, is worsening according to some observers. So the world needs at least 4-6 MMB/D of new supply to balance current consumption of around 98 MMB/D. Concern is growing of a shortfall.

Although blaming the Shale Revolution for a looming supply shortage sounds implausible, Shale’s lower risk profile is drawing capital investment away from conventional projects. You can see this in Exxon Mobil’s (XOM) five year plan to commit $50BN to North American oil and gas production. You can also see it in the dramatic decline in the size of large projects. As we’ve noted before (see The Short Cycle Advantage of Shale) conventional oil and gas projects take far longer to return their capital invested than shale projects.

The energy business has always been cyclical for this reason, because of the supply side’s slow response function. Shale’s ability to recalibrate output much more responsively to price can smooth out the cycle, if there’s enough short-cycle supply available. But there isn’t. North America is the major source of such projects and virtually the only source of shale activity. Rising U.S. output is nonetheless insufficient to provide adequate supply.

Conventional projects have always had to consider macro factors, such as global GDP growth, commodity prices and production cost inflation before committing capital. Add to those the likely path of government policies aimed at curbing fossil-fuel related global warming, and the unknown pace of technological improvement with electric vehicles. Today it’s probably as hard as it’s ever been to confidently allocate capital to a conventional oil or gas project with a 10+ year payback horizon.

Moreover, short-cycle projects like Shale lurk in the background, capable of wrecking the market with oversupply, yet able to protect themselves by quickly curtailing production.

This uncertainty is limiting the commitment of capital to conventional projects. If the warnings are prescient, oil prices will rise to a level that induces more investment back in to conventional projects. The market will self-correct. But it’s looking increasingly likely that higher prices will be required in the meantime.

Although MLPs are cheap by historical standards, the persistence of their attractive valuation should prompt observers to think a little harder. The almost 5% yield spread between the Alerian MLP Index and ten year treasuries is 1.5% wider than the 20-year average of 3.5%. However, the MLP yield spread to treasuries has been historically wide since 2013.

What an investor regards as a cheap security is, for the issuer, an expensive source of capital. Market gyrations create opportunities, but a temporary mispricing can evolve into a permanent one. The buyers and issuers of such securities are in effect debating whether such a shift has occurred.

The list of companies concluding that a shift has occurred includes all those who have converted from the traditional MLP structure with a General Partner (GP) earning Incentive Distribution Rights (IDRs). In 2014 Kinder Morgan (KMI) became the first large MLP to decide that something fundamental had changed in the MLP investor, and converted to a corporation. As regular readers know, we believe the Shale Revolution upset the prior business model. Before hydraulic fracturing and horizontal drilling unlocked America’s enormous reserves of hydrocarbons, energy infrastructure companies had a limited need to reinvest profits.  Our existing network of pipelines, processing facilities and storage was adequate to the task. Hence, MLPs distributed most of their cashflow in a tax-advantaged form, which attracted income-seeking investors.

In recent years, unconventional oil and gas extraction from previously untapped areas has required new infrastructure. Financing this disrupted the high payout model, leading to distribution cuts which alienated long-time investors (see Will MLP Distribution Cuts Pay Off?).

KMI was followed by many other large MLPs (see What Kinder Morgan Tells Us About MLPs), eventually including Targa Resources (TRGP), Oneok (OKE), Tallgrass (TEGP), Williams Companies (WMB) and Enbridge (ENB). Although there were some differences in structure, all these companies ultimately sought access to the wide pool of global equity investors. They’ve moved beyond the older, wealthy Americans who had long held MLPs for income and didn’t mind the K-1s. This narrow pool of buyers was not suited to finance growth businesses.

The MLPs that converted to corporations, including those listed above, have explicitly acknowledged this inadequacy of the traditional MLP investor. Many of those companies who remain MLPs are nonetheless mindful that the structure may not always suit them. Crestwood (CEQP) CEO Bob Phillips has said, of conversion to a corporation, that, “we won’t be the first, but we won’t be the last either.” Every MLP CFO is regularly asked about their structure.

On the other side of the Corp vs MLP debate are the managers of MLP-dedicated funds, including the Alerian MLP Fund (AMLP), and numerous other tax-burdened vehicles (see MLP Funds Made for Uncle Sam).

While the biggest MLPs are converting to corporations, it isn’t easy for these specialized funds to follow them. A taxable MLP fund that invested in a taxable corporation, delivering taxable returns to investors, would look absurd. But converting an MLP-dedicated fund to a RIC-compliant structure would require dumping 75% of their portfolio in order to comply with the 25% limit on MLPs. This would be hugely disruptive. With over $50BN in various poorly structured vehicles, they must all be hoping that none of their peers decide to become RIC-compliant, because it would depress MLP prices and lead fund investors to fear that others would follow (see The Uncertain Future of MLP-Dedicated Funds).

Faced with unpalatable choices, the managers of such funds naturally enough like their MLP-only approach.

As the chart shows, since the FERC ruling in March which caused many to reconsider the MLP structure (see FERC Ruling Pushes Pipelines Out of MLPs), diversified energy infrastructure has handily beaten MLPs. The American Energy Independence Index (AEITR) consists mostly of U.S. and Canadian corporations as well as having 20% allocated to the largest MLPs.  Driven by its heavy exposure to corporations, the AEITR has delivered an 8% higher return than the Alerian MLP Index. Moreover, investors in AMLP and other MLP-dedicated funds have to contend with the corporate tax drag which further impedes their return. The broader investor base available to corporations means better liquidity, which in turn attracts additional capital. Clearly, the companies that converted from MLPs can feel their choice was vindicated. Even Alerian CEO Kenny Feng concedes that the midstream sector, “…is in a bit of an identity crisis.”

The lesson here is that when a sector stays cheap for an extended period of time, perhaps something has fundamentally changed. Along with many of the largest energy infrastructure corporations, we think it has.

We are invested in CEQP, ENB, KMI, OKE, TEGP, TRGP, WMB.

We are short AMLP.

Volatility is not the investor’s friend. Some will immediately take issue with this – volatility caused by falling prices can mean opportunity, and volatile rising prices are surely welcome. While true, investments that gyrate cause investor stress which often leads to poorly timed sell decisions. Although a company’s long-term profitability should be more important, the downside of liquid equity markets is that they offer a constant evaluation of your decisions.

For many years before the Shale Revolution took hold, MLPs were known for stable, attractive yields. Companies paying out 90% of their Distributable Cashflow found income-seeking investors. This idyllic relationship suffered a nasty break-up once growth opportunities led to reduced distributions. Although justified, in order to lower leverage and fund new projects (see Will MLP Distribution Cuts Pay Off?), many investors felt betrayed.

As investors recall only too well, the result was a collapse in MLP prices bigger than occurred during the 2008 Financial Crisis. Midstream infrastructure businesses responded by strengthening balance sheets and, in many cases, converting to corporations. Older, wealthy Americans attracted to stable, tax-deferred MLP distributions are a poor match for growth businesses. The narrowness of the investor base, combined with uncertainty over how FERC will implement its revised policies on cost of service pipeline contracts (see FERC Ruling Pushes Pipelines Out of MLPs), have convinced most of the biggest energy infrastructure companies to organize as corporations. This makes their stock available to a far wider set of buyers.

For years, MLP prices were roughly as volatile as the S&P500. This relationship broke down in 2014 when the Energy sector endured its own bear market, leading to substantial performance divergence between the two.

But there are signs that the lower volatility of the past is returning. Companies are continuing to reduce leverage. 4X Debt/EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is now preferred to 5X. Financing of growth projects is far less reliant on issuing public equity. Distribution coverage is going up, even at the near term expense of distribution growth. Enterprise Products Partners (EPD) last year told investors to expect slower distribution hikes so they could redirect cash towards attractive projects. It’s worth noting that the high volatility of 2016 (defined as average daily moves of >1% over the prior year) is historically rare, occurring only 8% of the time since 1996.

Perhaps most importantly, the shift to a corporate structure is dramatically broadening the investor base, and this added stability is further reducing the sector’s volatility. The American Energy Independence Index provides broad exposure to North American energy infrastructure, with 80% corporations and only 20% in the biggest MLPs . It has 16% less volatility than the Alerian MLP Index, a meaningful improvement.

Given the well-established trend of larger MLPs to convert to corporations, this metric is likely to continue pointing away from an MLP-focused approach to the sector. As volatility returns to the lower levels that have predominated over the past 20-odd years, it’s likely that returns will also improve.

2013 and 2014 were great investing years. The S&P500 was +32% in 2013 and followed up with +14% the following year. MLPs also delivered strong performance. As long-time investors know, the Alerian MLP Index peaked in 2014 and even now remains 35% lower, while the S&P500 has continued to scale new heights.

Investors in MLP-dedicated mutual funds and ETFs yearn for a repeat, and probably feel entitled to one. Investors in such products are generally not looking for 5-10% either. Given what the sector has endured, the returns of 4-5 years ago would not be amiss. Last week the sector finally turned positive YTD — such optimistic thoughts do not seem out of place.

Those hoping for such may want to consider their choice of vehicle. MLP-dedicated funds are taxed as corporations, and so they pay taxes as well as other operating expenses before delivering their taxable returns to investors. These funds labored under some of the highest expense ratios in the industry during those banner years. Their tax expense is fully disclosed, but still in our experience poorly understood. Sitting with a financial advisor and educating him on a previously unfathomable expense burden still routinely elicits embarrassment and shock.

The chart below shows the 2013-14 expense ratios of some of the biggest MLP-dedicated funds. Although corporate tax rates are now lower, the structural inefficiency persists. If MLPs do manage a couple of years of outsized performance, investors are likely to be surprised at the expenses that are deducted from their returns. Getting the sector right but picking the wrong investment is an avoidable tragedy (see AMLP’s Tax Bondage).

In 2013, the funds in the chart had an average expense ratio of 9.4%. With average returns of 18.2%, around a third of the gross return was eaten up in expenses, most of which was corporate taxes. Six years ago in The Hedge Fund Mirage, I showed how the profits had split very unevenly between fees to managers versus returns to clients. It surprised many, although not the fund managers who well understood and enjoyed the imbalance. The 2013-14 result in MLP funds was similar, although the offending expenses in this case are corporate taxes rather than manager fees. Nonetheless, considering that investors still have to meet their own tax liability on the net investment results, these look like products that the Federal government might have designed.

Promoters will explain that all MLP funds are taxable, which is true. When investing in energy infrastructure meant MLPs, that was perhaps a defensible argument. But many of today’s biggest energy infrastructure businesses have abandoned the MLP structure. They’ve found the investor base to be fickle, limited to older wealthy Americans who prefer income and are unwilling to finance the growth opportunities opened up by the Shale Revolution. These long-time buyers have been badly abused, with multiple distribution cuts and adverse tax outcomes when their MLP simplifies by combining with its corporate parent. It should be no surprise that MLP yield spreads versus ten year treasuries remain historically wide.

In May, Williams Companies (WMB) rolled up their MLP into their corporate parent (see Transco Dumps Its MLP). Enbridge (ENB) also simplified their structure on the same day. Both cited regulatory uncertainty caused by the FERC ruling (see FERC Ruling Pushes Pipelines Out of MLPs). But the difficulty of raising equity capital for an MLP is an issue for many.

As a result, tax-burdened MLP-dedicated funds are now confronting a shrinking set of opportunities. They are becoming an anachronism, as the energy infrastructure industry steadily leaves the MLP buyer behind in favor of a far bigger set of investors.

Moreover, the shrinking MLP universe is going to create further challenges for such funds (see The Alerian Problem). At the annual MLP conference in Orlando, many participants commented that an MLP-only index was now inadequate, no longer reflective of the energy infrastructure sector (see The Uncertain Future of MLP-Dedicated Funds). MLPs are less than half of North American midstream energy infrastructure, a point recently tweeted by Hinds Howard of CBRE Clarion Securities (@MLPGuy).

Managers of MLP-dedicated funds are telling their clients not to worry — as they would given their MLP-centric business model. But a shrinking index is rare in Finance, and offers the fund manager few good options: (1) Do nothing, and hope your clients tolerate a more concentrated portfolio with smaller names; (2) Start holding corporations as well as MLPs. This would require an ingenious explanation, because you’d now have taxable corporations sitting in a tax-paying fund delivering taxable returns to investors, a solution with poor optics; (3) Switch to a broader index and become RIC-compliant. This is the nuclear option, since it requires an MLP-dedicated fund to shed 75% of its holdings in order to come under the 25% MLP limit necessary to be RIC-compliant. If the $10BN Alerian MLP ETF (AMLP) sold $7.5BN of MLPs, they’d find that by the time they were done with that, for MLP prices, down is a long way. It’s unlikely they could seriously contemplate such a choice — their investors should hope they never do.

AMLP is the biggest of these flawed funds. In 2013-14 its expense ratio was 8.6% and 8.8% respectively. Today, AMLP has modest unrealized losses; a continued recovery in the sector will soon turn these into gains, resulting in AMLP once again incurring a Deferred Tax Liability along the lines of 2013-14. Since it’s close to the inflection point at which it becomes a taxpayer, shorting AMLP exploits the attractive asymmetry of a tax drag impeding its rise, while it will still reflect the full force of a market drop. It’ll rise at approximately only 77% of the index, and fall 100% of it. AMLP as a short can be combined with a long position in a portfolio of energy infrastructure corporations, or even with a correctly structured, RIC-compliant fund with no tax drag. Such a paired trade combines long positions focused on energy infrastructure corporations, which have very strong fundamentals, with a short position focused on the MLP structure than is increasingly being abandoned.

We are long ENB and WMB. We are short AMLP.

On the University of Texas website is a documentary titled Gift from the Earth: Natural Gas. It describes the construction of a pipeline to transport natural gas from Texas to population centers on the east coast, as far away as New York City. The pipeline was built by the Transcontinental Gas Company (Transco), and the documentary is from the 1950s.

Today, Transco has grown into America’s largest natural gas pipeline network. Since 1995 it’s been owned by Williams Partners (WPZ). With some justification, WPZ management describes it as irreplaceable – the cost to acquire the land and easement rights combined with the infrastructure itself would run into the tens of $Billions. WPZ is 6.6% of the Alerian MLP Index (AMZ) and 8.1% of the Alerian MLP Infrastructure Index (AMZI). It will soon be leaving.

Williams Companies (WMB) is WPZ’s corporate parent. They concluded that the advantages of having an MLP had diminished, and that their business will grow faster by rolling up the remaining publicly held units of WPZ (WMB already owns 74%) into the parent. Oneok Inc. (OKE), which absorbed its MLP last year, has an Enterprise Value/EBITDA multiple of 15-16X, a valuation WMB must feel is attainable from its present 11-12X.

MLPs retained their tax-free status through last year’s tax reform. The problem is that the investor base remains frustratingly narrow. Those who face tax hurdles in buying MLPs include tax-exempt U.S. institutions and non-U.S. buyers, together a substantial percentage of U.S. equity holders. Most individuals are put off by the K-1s rather than 1099s for tax reporting. That leaves older, wealthy Americans whose accountants prepare their tax returns as the main source of equity capital.

Given their dependence on a fairly limited set of buyers, you might think MLPs would have treated them better. These holders were attracted by high, reliable tax-deferred payouts combined with modest growth. The Shale Revolution created new business opportunities that raised leverage, leading to slashed distributions (over 50 so far), and simplifications that come with a tax bill. Betrayed, these older, wealthy Americans now regard with skepticism MLP yields that are historically high, thereby raising the cost of equity capital for the sector.

Having destroyed their original buyers’ appetite, many companies have concluded that they need access to all the global equity investors, which requires being a corporation. On the same day that WMB announced their roll-up transaction, Enbridge Inc (ENB) made a similar move with their four sponsored vehicles, including MLPs Spectra Energy Partners (SEP) and Enbridge Energy Partners (EEP).

Uncertainty over FERC policy (see FERC Ruling Pushes Pipelines Out of MLPs) has also weighed on the sector, prompting some considering incorporation to move ahead.  WMB and ENB are the most recent in a steady stream of companies abandoning the MLP structure. In the past couple of months three other MLPs have made similar announcements, representing in aggregate 13.3% of AMZ (benchmark for numerous funds) and 15.5% of AMZI (benchmark for the Alerian MLP ETF, AMLP) which, absent further changes, will drop from 26 constituents today to 21.

This need not matter for direct holders. If your MLP is absorbed by its corporate parent, your MLP units are swapped for corporate equity securities. The assets are still there. In a now familiar routine, as they part with their WPZ units, WPZ holders will receive a tax bill for deferred income tax as well as a dividend cut (since WMB’s $1.36 dividend multiplied by the 1.494 exchange ratio is $2.03, 17% lower than WPZ’s current $2.46 distribution). It’s WPZ’s third cut in the last four years, so they must be getting used to it. Meanwhile, WMB will create a tax shield for itself through a stepped up cost basis on the acquired WPZ assets, making it 2024 before they’ll be a cash tax payer. This common benefit first drew attention when used four years ago (see The Tax Story Behind Kinder Morgan’s Big Transaction).

The new WMB will finance its growth with asset sales and reinvested profits while reducing leverage. They expect 10-15% annual dividend growth. It’s generally all good for WMB investors. But for many, the bigger story continues to be the impact of a steadily shrinking MLP universe on MLP-dedicated mutual funds and ETFs. AMLP and many MLP mutual funds now combine a tax-burdened corporate structure (see AMLP’s Tax Bondage) with a shrinking opportunity set that will soon exclude America’s biggest natural gas pipeline network. The problem has been growing (see Are MLPs Going Away? and The Alerian Problem).

In an amusing twist, during WMB’s investor day one analyst asked whether they’d considered maintaining Transco’s ownership within an MLP by shifting it into a blocker corporation. This is similar to the structure used by tax-burdened funds such as AMLP. WMB CEO Alan Armstrong replied that the additional corporate tax liability rendered such a solution uneconomic through multiple layers of taxation. In other words, the structure by which AMLP holds WPZ is regarded as unworkable when considered by parent WMB.

The promoters of such poorly structured funds deny a problem, which leaves it to their investors to do their own homework. Fewer MLPs may even cause investors to exit such funds in search of more diversified exposure, depressing prices. ENB’s press release referred to, “…the continuing deterioration in the MLP equity marketplace.”  Their presentation asserts that, “Sponsored vehicles are ineffective and unreliable standalone financing vehicles.” MLPs aren’t going away, but they’re clearly not an attractive choice for companies in need of equity capital to grow.

The problem is one of structure, not fundamentals. U.S. hydrocarbon output is hitting new records, in some cases leaving the infrastructure struggling to keep up (see Dwindling Pipeline Capacity Causes FOMO). The appeal of broad-based, tax-efficient energy infrastructure using mostly corporations is strong.

We are invested in ENB, KMI and WMB. We are short AMLP