Is NextEra Running in Place?

Investing in midstream energy infrastructure today means pipelines, storage, gathering and processing and all the physical networks that sit between oil and gas wells and their customers. It doesn’t have to be limited to servicing non-coal fossil fuels. We research and think about other sources of energy including nuclear, renewables and coal.  We prefer the more visible cashflows that come with handling and transporting energy over the cyclicality and capital intensity of production and generation. It’s why we have avoided upstream oil and gas, coal mining, and power generation companies.

Mining and burning coal releases many pollutants including nitrous oxide, sulfur dioxide, particulate matter and other pollutants. It is in long-term decline in North America.  Furthermore, transportation is by rail and ship, which have lower barriers to entry than pipelines.

Public opposition to nuclear has added uncertainty and harmed economics, which makes investing unattractive.

However, renewables offer the opportunity for both long haul transmission lines and large scale storage. These are two areas with the potential for visible, persistent cashflows, although today there are few opportunities for scale and pure plays. Renewable generation is largely owned by utilities within portfolios that include coal, natural gas, and nuclear assets.

NextEra Energy Projected Capital Expenditures

An exception is NextEra Energy (NEE), the world’s biggest producer of wind and solar energy. They’re the largest component of the SPDR Utilities ETF (XLU). On a list of countries ranked by wind power generation, they would be 8th. Just as the Shale Revolution has created ample opportunities to invest capital for growth, so has the burgeoning renewables business in the U.S., albeit with a wholly different response from investors.

Although energy investors have revolted against endless investments in more production and additional pipelines, NEE investors cheer the company’s stepped up commitment to renewables. Over the past year, their stock has returned 24%,  8% ahead of the S&P500 and 16% ahead of XLU. From 2015-18 NEE’s capex rose from $3.9BN to $6BN, a pace they expect to maintain over the next four years. They’re planning the world’s biggest battery center by a factor of 4X, in central Florida, to store intermittent renewable energy for later use when it’s not sunny or windy.

Strong Growth Projected in Renewables

Much of this investment will be in new wind and solar generation, a sector NEE expects to enjoy 15% annual growth through 2030. This growth will be driven by declining prices for produced power. NEE expects improving technology to bring the cost per Megawatt Hour for wind and solar below all other sources.

CEO Jim Robo recently led an investor day during which his team enthused about the being a low-cost renewables company delivering the benefits of clean energy to customers and investors.

Renewables Power Prices to Fall

But here’s the catch. The company is plowing capital into assets that will depreciate, because continued efficiencies will lower the price of produced power. It’s analogous to holding a huge inventory of microchips when Moore’s Law dictates that the cost of computing power falls by 50% every 18 months; or of stocking millions of iphones, when the next version will drive down the price of the old ones.

Rapid advances in technology cause deflation in assets. While Intel and Apple have shown that it’s highly profitable to manufacture products with continuous improvement, NEE is on the other side of this trade.

It means that every windmill they install and every battery facility they build is worth less than it cost from the moment it begins operation. The falling cost of renewable energy, which is driving their pursuit of growth, threatens to erode the pricing power of the assets they’re developing.

Correctly assessing the cash flow generating capability of a new solar facility must be hard. NEE can depreciate their property, plant and equipment (PP&E) based on the physical useful life of what they’ve bought, but the impact on cashflows from future pricing pressure is less clear. As their installed asset base ages, they’ll become less competitive, unless they constantly reinvest to upgrade their depreciating equipment. They face a constant uphill struggle to maintain competitive, cost-effective assets.  Eventually, they’ll reach a cash flow cliff as their contracts roll off.

In 2018, NEE’s depreciation of its renewables-heavy PP&E jumped, and is now higher than peers Duke Energy (DUK) and Dominion Energy (D), the 2nd and 3rd largest components of XLU respectively. At $3.9BN, it was two thirds of their growth capex. In other words, two thirds of their capex is spent to preserve the value of their PP&E. Assuming straight line depreciation, NEE expects its existing asset base to have a useful life of just over 18 years, which contrasts with the 35X earnings multiple assigned its stock by the market. Free Cash Flow has been declining as a percentage of net income, and will shift negative this year.

NEE is a company that’s investing heavily in the future, but will always be racing against advances in renewable technology. A purchase delayed will provide cheaper power, later. Advances in renewables may one day cause an impairment charge on old assets struggling to compete. A 10% write-down in PP&E would wipe out a year’s profits.

The irony is that pipelines regularly raise prices, and the sector has been punished by investors for spending on new infrastructure to transport growing oil and gas output. Disruptive pipeline startups are rare, because expanding an existing pipeline brings network effects and is cheaper than building new. Moreover, FERC’s regulatory framework  recognizes the oligopolistic role pipelines play and is designed to limit egregious pricing.

By contrast, NEE is being rewarded for investing heavily in assets whose pricing power diminishes. It’s true their customers are locked in via long term power purchase agreements. One of these is being challenged by bankrupt PG&E in California, although NEE is confident it will be upheld. But they still face the risk of lower-priced competition in the future, and no-one knows if regulators will allow them to charge customers rates above what new power assets would dictate indefinitely. Their potential competitors include new entrants unburdened by legacy, inefficient infrastructure. Even their customers can turn into energy providers by adding rooftop solar panels. The technology around renewables and battery storage continues to improve, creating the possibility of further disruption by new entrants.

We don’t own NEE. By all accounts they are a well-run company. Their progress will provide a useful guide to the growth of renewables in the U.S. and their ultimate profitability.

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).

Reviewing Russell Gold’s The Boom

Although Russell Gold’s The Boom: How Fracking Ignited the American Energy Revolution and Changed the World is now almost five years old, it still provides a relevant commentary on America’s Shale Revolution. Unlike many other chroniclers of America’s energy renaissance, Gold managed to obtain an invitation to see first-hand how drillers unlock hydrocarbons from shale. We already know it’s a noisy, dirty process that’s highly disruptive to the local community. But we also learn about the intersection of science with the brute force required to fracture the rock holding the commodity. Huge trucks carrying water and pump trucks converge on the drilling site. Inside the trailer where technicians control the process, “The computers, the headphones, and the focused faces make the van feel a bit like a NASA command center.” But they’re still oil sector workers, so better resemble a NASCAR pit crew working at NASA.

The Boom By Russell Gold

Gold highlights Shale’s huge benefits to the U.S. Oil companies have known for decades that impenetrable source rock held enormous reserves. Early efforts at fracturing it used high explosives, and in the 1960s there was serious discussion about using nuclear bombs. Between 1969 and 1973 several nuclear devices bigger than the one dropped on Hiroshima were detonated underground to release natural gas. Subsequent production wasn’t impressive, and poor economics as well as environmental concerns soon ended such efforts.

The author balances the positives with concerns about drilling’s local environmental impact, as well as the continued use of fossil fuels. He concludes that increasing natural gas use is the preferred outcome because it displaces far dirtier coal plants for electricity generation. In time, like many observers, he expects renewables to dominate, but that’s still likely decades away. Battery storage continues to be a significant hurdle to relying on intermittent sources of energy such as solar and wind. Bill Gates noted this in a recent blog, writing that, “…solar and wind are intermittent sources of energy, and we are unlikely to have super-cheap batteries anytime soon that would allow us to store sufficient energy for when the sun isn’t shining or the wind isn’t blowing.”

It turns out oil is a fantastically efficient form of energy storage. A memorable illustration comes from a speech by Steven Chu, former U.S. Energy Secretary under Obama. In comparing different materials for their energy density per unit of weight, or volume, he noted that, “The most efficient energy sources were diesel, gasoline and human body fat” (italics added). Apparently, an ample girth has energy storage capabilities to which battery developers aspire in their labs. Chu added that a battery holding a comparable amount of energy would require eighty times more space and weight. This was back in 2010, but today’s best batteries still don’t come close.

Gold identifies privately owned mineral rights as a crucial difference between America and the rest of the world. Although English Common Law underpins the U.S. legal system, sovereign ownership of what’s underground is one attribute that happily didn’t cross the Atlantic. The sharing of wealth with the community where drilling takes place is an important pillar of support. In 2014 when The Boom was published, fifteen million Americans lived within a mile of a well that had been fracked within the past few years. Today’s it’s certainly more. Although proximity produces supporters and opponents, generally fracking happens where it’s welcome, which is as it should be. Since Gold’s initial interest in the subject was due to Chesapeake buying drilling rights on his family’s farm, his perspective is well informed.

The rise and fall of Aubrey McLendon, late founder of Chesapeake, take up two chapters. McLendon was a colorful character who thought big and took the industry to higher gas production than would have happened without him. The Boom was published before McLendon’s fiery death in an automobile accident. It looked like suicide, occurring in March 2016 when the energy collapse was straining his high risk business strategy, but was later ruled accidental.

It’s also interesting to learn about the career of George Mitchell, often called the father of fracking. Mitchell’s persistence with unlocking shale reserves where others had given up is now industry legend.

The Boom deserves a place on the bookshelf of anybody interested in learning more about the Shale Revolution.

Join us on Thursday, July 11th at 1pm EST for a webinar. We’ll discuss the pipeline sector’s growing Free Cash Flow. To register, please click here.

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).

Texas Reconsiders Flaring

Nothing exemplifies America’s low natural gas prices more than its flaring where takeaway infrastructure is inadequate. In the Permian basin in West Texas and New Mexico, from where most of the growth in crude production originates, associated natural gas is more often a disposal problem, like wastewater. Oil production has grown faster than expected, leaving gathering and processing systems struggling to keep up. Natural gas is hard to handle. Transportation by truck isn’t common because it has to be compressed, requiring specialized equipment. Mexican utility demand has grown more slowly than planned, and absent pipelines for transportation elsewhere in the U.S., the only remaining option is flaring.

natural-gas-flaring

A few years ago North Dakota faced a similar problem. Nighttime satellite photos revealed what looked like a new, brightly lit city in an uninhabited part of the country. Although regulators typically allow flaring for limited periods of six months or so, volumes of wasted gas continue to grow. By one estimate, the natural gas currently being flared in the Permian could power every home in Texas. The Texas Railroad Commission (RRC) regulates flaring permits. Oil drillers routinely request and receive permission for flaring where they can argue that oil can be profitably produced but there’s no take-away infrastructure for natural gas.

In theory, flaring requests can be challenged although they never are. Last week the RRC heard an application which raised an interesting question whose resolution could have a profound impact on such permits in the future. Exco Operating Company, LP sought a flaring permit on the basis of unavailable pipeline infrastructure. Unusually, it was protested by Williams Companies (WMB) who owns a nearby gathering and processing network. You can watch a video recording of the hearing here. Go to Item 9.

It turned out that a gathering pipeline was available to transport the associated natural gas, but Exco felt the economic terms were unfair. As the owner of the only available pipeline, Exco argued that WMB could charge an unfairly high price. Natural gas pricing at the Waha hub in Midland, TX has often been negative this year, meaning gas producers have to pay to offload their output. So it’s likely Exco was balking at pricing that reflected the paucity of options.

This led to an interesting dialogue between the RRC commissioners and representatives of Exco and WMB. The RRC has traditionally been charged with minimizing the waste of oil and gas. Natural gas flaring has been allowed because it’s necessary to access the crude oil. But Exco’s argument was one of economics. Implicit in their flaring request was that disposing of the natural gas would cost them more than its value.

As one commissioner noted, if flaring permits were based on economic hardship, there would be no need to have an approval process because companies would simply flare when that provided a better return than accessing a pipeline. And yet, the RRC is charged with regulating flaring, which means there must be some other, non-financial framework they’re intended to follow.

It was fascinating to watch both lawyers and the commissioners spar over this issue. WMB noted that the pipeline had been built at a cost of $1.5BN in order to gather gas from wells such as Exco’s, and said that Exco could have built their own takeaway pipeline early in the process but chose not to.

The RRC recognized the fundamental question raised by WMB’s challenge to Exco flaring application. It seems that however it’s resolved, it will set a precedent for future applications. Exco’s view would negate the need for the RRC to regulate flaring, since the decision would be a financial one for the company. WMB’s view would require drillers to access a gathering system where available even if pricing was unattractive.

The RRC decided to pass on the case at its first hearing, leaving it currently unresolved. When they meet to reconsider, the result could be far-reaching. If the RRC requires drillers to use available gathering and processing networks regardless of economics, as WMB wants, that would be good for pipeline investors.

Join us on Thursday, July 11th at 1pm EST for a webinar. We’ll discuss the pipeline sector’s growing Free Cash Flow. To register, please click here.

We are invested in WMB.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Pipelines Get Adult Supervision…Private Equity

Last week’s blog (see Plain Talk, Fuzzy Math) showed how Plains All American (PAA) miscalculates its cost of equity capital. Equity is the key component in a company’s Weighted Average Cost of Capital (WACC). In the presentation from their investor day, it was too low. We received several comments from readers and investors on the topic. The energy industry has been plagued with executives who value growth in assets over achieving an appropriate Return On Invested Capital (ROIC). Profits come from ensuring that a company’s assets earn a return higher than the cost of financing them, or that ROIC > WACC.

Return of Capital v Cost of Capital for pipeline companies

In one meeting with PAA, we asked if they’d considered selling themselves, since there’s a case that the company’s worth more in another’s hands. “Not yet ready to retire” was the answer. Financial discipline comes in many forms.

In too many cases, a CEO’s pay is directly linked to a company’s size. Per share operating metrics and capital efficiency ought to dominate. Management teams often strive for growth, which can conflict with an owner’s desire to earn a good return. Identifying companies where interests are more clearly aligned with investors is worthwhile.

Calculating ROIC for energy infrastructure businesses is tricky. Projects are funded over several years, and project-based returns are generally not disclosed. Therefore, some judgment is required. Wells Fargo made a serious attempt at calculating company-specific ROIC figures last year. A couple of companies (Enterprise Products and Plains) preferred their own methodology over that used by Wells Fargo, and their objections were duly noted in the research report. We explained in last week’s blog why we disagreed with PAA’s approach.

Pipeline Companies Five Year Return on Capital

One solution to poor capital allocation decisions is to favor public companies with a significant private equity investor. At first this might seem odd. Private Equity (PE) has delivered mediocre results for investors (see a recent WSJ article, Private-Equity Firms Are Raising Bigger and Bigger Funds. They Often Don’t Deliver). The problem for PE investors is the ubiquitous “2 and 20” fee structure, which is a big drag on returns and has created some fabulous fortunes. However, most PE managers are financially more astute than the typical pipeline company finance department. The best apply rigorous financial analysis, and investing alongside them can be an attractive proposition.

Pipeline companies with a large private investor

Having a PE partner doesn’t guarantee good judgment, but it does assure that when such decisions are being made, there will be a voice demanding a profitable spread between ROIC versus WACC. Private equity is all about capital efficiency and achieving an attractive IRR. Many energy companies could benefit from greater financial discipline. A few already have such a partner, reflecting the more optimistic outlook PE investors have of the sector compared with public market valuations.

Blackstone and its affiliates own 44% of Tallgrass Energy (TGE). Investors in TGE are in effect co-investing alongside Blackstone, without having to pay Blackstone a fee. It’s appealing to all TGE holders to know that capital allocation decisions require Blackstone’s support.

Crestwood (CEQP) is a similar situation, with their private equity partner First Reserve, who own 25% of CEQP and has also invested in JVs with CEQP on mutually beneficial terms.

Activists can also play a constructive role. In 2016 Carl Icahn pushed Cheniere’s (LNG) CEO Charif Souki out of the company. That’s one solution to the principal-agent problem. Souki is a colorful character (see Coals to Newcastle), but Icahn disagreed with LNG’s investments in oil companies, which were not linked to their core business of exporting liquefied natural gas. In an interview with CNBC, Icahn explained why, and also vented his frustration with Souki’s compensation. The subsequent improved capital allocation and focus on executing their core business plan has seen LNG stock rise from $39 at the time of Icahn’s intervention to $66 today, without paying a dividend.

Enterprise Products Partners (EPD) has a well-regarded reputation for prudent management. Growth projects are funded internally. The Duncan family owns a third of the company and controls EPD, helping align shareholder interests with managements.

Global Infrastructure Partners recently invested in Enlink Midstream (ENLC), and currently owns 41%. Texas Pacific Group and Goldman together own 12% in preferred securities which are convertible into common equity. It’s too early to judge the impact of their ownership, but encouragingly ENLC’s CEO Mike Garberding was previously the CFO. We think it’s highly likely that capital discipline will become apparent at ENLC.

Significant equity ownership by management doesn’t always lead to good decisions. Rich Kinder continued to add to his already significant holding in Kinder Morgan (KMI), even as it lost two thirds of its value from 2015-16. KMI investors could have benefitted from an influential outsider. Energy Transfer (ET) is also heavily owned by management, but trades at a steep valuation discount because CEO Kelcy Warren has shown a willingness to exploit his investors if he can (see Will Energy Transfer Act with Integrity?).

Prior to their simplification, the significant insider ownership at Plains may have led the GP to place too much leverage at the MLP level, leading to unsustainable dividends at the MLP before consolidation. In some cases, management teams whose interests weren’t aligned with investors under the old GP-MLP model have not yet altered their behavior to acknowledge the alignment of interests that simplification brings.

The addition of PE investors makes creating value for all stockholders a higher priority.  This requires disciplined capital allocation.  While Rich Kinder, Kelcy Warren, and the insiders at Plains still own significant stakes, they are holdovers from a different model of wealth creation.  Under their old structure, the GP directed the MLP’s activities while receiving preferential economics through Incentive Distribution Rights (IDRs).  Growing the MLP increased IDRs even if it diluted returns for MLP investors.

Kinder’s simplification was almost five years ago, and yet their continued use of DCF and EBITDA in evaluating their Enhanced Oil Recovery (EOR) business betrays that they still haven’t updated their thinking. Depleting assets such as these reduce the return earned by equity holders, while the GP and his IDRs are largely immune. As a simplified, single entity KMI still hasn’t shown that it understands its long term ROIC for the EOR business.

Plains is using flawed math for capital allocation decisions.  And, Kelcy may be back on the hunt for acquisitions to continue building his pipeline empire at ET.

The energy sector has been roundly criticized for overinvesting. Investors who favor companies where the rigor of PE analysis is applied to future projects could find that better capital allocation decisions follow. In our portfolios, we are biased towards companies likely to choose their investments wisely.

We invest in CEQP, ENCL, EPD,  ET, LNG, KMI, TGE, PAA via Plains GP Holdings.

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).

Oil and Gas Growth Powered by U.S.

Last year the U.S. set a new world record for annual increase in production of oil and gas by any country in history. The recently-released BP Statistical Review of World Energy 2019 highlights these and many other useful facts.

U.S. Sets Record in Oil Production
U.S. sets World Record in Natural Gas Production

Total U.S. energy consumption rose by 3.5% last year, the fastest in 30 years and a surprising jump following a decade of no growth. Growth in population and GDP have normally been offset by lower energy intensity and improving efficiency. But periods of extreme weather (both excessive heat and cold) boosted energy demand, as well increased use of ethane for America’s resurgent petrochemicals industry.

US Annual Energy Consumption

The U.S. was one fifth of the 2018 increase in global energy consumption, with China and India together representing half. Climate change and CO2 emissions figured prominently in the report. Developed countries desire lower emissions and emerging countries higher living standards. China consumes 42% more energy than the U.S., a gap that will grow in the decades ahead. The resolution of these conflicting goals dominates the outcome.

Per Capita Oil Consumption US v China and India

So it’s worth noting that the Asia-Pacific region energy consumption is more than double North America’s, and half of this comes from coal. The difference in coal volumes is by a factor of 8X. China alone consumes 6X as much coal as the U.S. But to illustrate unmet energy demand, China and India’s per capita consumption of crude oil is only 10% that of the U.S.

World Energy Consumption by Fuel

Until we confront these twin issues, little else that’s done to reduce emissions will have much impact.

Global carbon emissions grew by 600 million tons, or around 2%, the fastest for many years. This is the equivalent of increasing the global passenger car fleet by a third. Last week, India’s Adani Mining won Australian regulatory approval to begin developing one of the world’s largest untapped coalmines. Its critics contend that this project alone will eventually add 700 million tons of CO2 emissions, exceeding last year’s global increase from all sources. This is where India’s desire for more energy to raise living standards manifests itself. New York’s environmental extremists opposing a new natural gas pipeline might consider where the real problem lies.

Increased use of renewables alone will not solve the issues of climate change. BP notes that simply maintaining carbon emissions from the power sector at 2015 levels would have required growth in renewables generation at more than double the actual rate. The additional output is equal to all of the U.S. and China’s 2018 energy output from renewables.

US Natural Gas and Renewables Consumption

Natural gas provided 43% of the additional power the world consumed, more than twice that provided by renewables. For all the excitement about increasing use of solar and wind, their share rose by 1.4%. 84.7% of the world’s energy came from fossil fuels in 2018, versus 85.1% in 2017. As Bill Gates and others have pointed out, R&D should be directed towards making the 85% less carbon intensive, rather than trying to replace what obviously works.

Netpower is developing the ability to generate electricity from natural gas with no emissions, which would represent a significant breakthrough if successful.

It’s still possible to find writers warning of a production collapse because of shale’s chronic unprofitability.  An article on Seeking Alpha (see Here’s Why Oil Stocks Are Priced For Armageddon) or Bethany Mclean’s Saudi America: The Truth About Fracking and How It’s Changing the World both reflect a simplistic view. Exxon Mobil (XOM), now the biggest driller in the Permian, clearly finds it profitable. Anadarko had two suitors for its Permian assets. Volumes keep growing, in defiance of some writers’ claims to better understand the economics.

BP’s report showed that the 2.2 Million Barrels per Day (MMB/D) of increased global crude oil production came from the U.S., a point echoed in Plains All American’s (PAA) Investor Day.

The path to lower global emissions requires far more use of nuclear power, far less coal use in China and India, and more R&D into using existing energy sources more efficiently. Otherwise, investments in seawalls and flood mitigation will be a safer bet.

We are invested in PAA, via Plains GP Holdings.

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).

Plain Talk, Fuzzy Math

Plains All American (PAA) held their investor day last week. Continued growth in output from the Permian in West Texas is driving new pipeline construction, for which PAA is at the forefront. Limited pipeline capacity has hurt economics for some drillers that have resorted to trucks to move their crude, which is far more expensive.

PAA’s Supply and Logistics (S&L) business thrives on infrastructure constraints, since it allows them to exploit basis differentials using spare capacity on their pipeline network. From 2014-17 S&L EBITDA collapsed by 90%, as spare capacity came online. It has since rebounded to $450MM, around two thirds of its 2014 peak.

One analyst asked about the impact of new pipelines, both on the S&L business (where PAA expects to see EBITDA drop 50% next year) as well as on existing pipelines which face possible cannibalization of demand:

“You’re creating your own weather when you think of the S&L impact…there’s a lot of moving parts here…Loss of marketing, loss of basin flows, loss of potentially some spot barrels on Bridgetex”

Executives wouldn’t be drawn into discussing the impact in more detail, which was a pity because an investor day is supposed to offer an opportunity to dig more deeply into a company’s business. The response was:

“The guidance for this year fully reflects our views of how that impact is…we’ll give guidance later in the year for 2020… I don’t think we’re going to specifically work towards guidance during this meeting today, that’s not the intent.”

This interaction captures the conundrum facing investors. The Shale Revolution’s dramatic increase in oil and gas production isn’t yet profiting midstream infrastructure investors. One reason is fear that the industry will overbuild, pressuring pipeline tariffs and leading to projects that fail to cover their cost of capital.

PAA laudably tried to demonstrate financial discipline with two slides illustrating how they think about their cost of capital versus their return on invested capital. For any company, the spread between these two is the main source of profits.

Cost of Capital PAA

So it was disappointing to see errors and omissions. Distributable Cash Flow (DCF) as a cost of equity was based simply on the current DCF yield without adding anticipated long term growth, though investors are told to expect such growth of 10% this year and presumably further growth beyond.

Return on Invested Capital PAA

The problem in using current EBITDA as the basis for assessing projects is that it doesn’t reflect the long term return on assets with years of useful life and fluctuating tariffs. It omits corporate overhead, maintenance, cost for potential delays and cost overruns. Most investors calculate the net present value of cashflows from a proposed investment, discounted using a rate appropriate to the risk.

How PAA Should Calculate its Cost of Capital

PAA isn’t calculating their cost of equity properly. More correct would be to use the dividend yield plus long term expected growth rate. The growth rate is derived from the portion of retained earnings not paid out (i.e.  1 minus the payout ratio) times the return on equity, which PAA shows has historically been 19.5%.

Although they’re targeting 130-150% coverage of their distribution, it’s currently 2X. Raising the dividend such that it was 150% covered would give them a yield of 8.5% (versus 6.37% currently). 150% coverage  equals a 67% payout ratio. 1 minus the payout ratio, or 33%, times their 19.5% ROE, implies a 6.5% growth rate, which should be added to the projected 8.5% dividend yield.

So PAA’s own figures and assumptions suggest their cost of equity is really around 15%, not the 12.1% they presented. PAA’s Weighted Average Cost of Capital (WACC), using their desired 55/45 equity/debt split and with a 4.25% interest rate on their debt, is almost 10.2%, 1.6% higher than they presented.

Since they seek an investment return of 3-5% above their WACC, any project needs a return of 13-15%. Riskier projects need an even higher return than this. The Alpha Crude Connector acquisition failed to meet this hurdle.

This minimum return on new projects is further illustrated through their desired leverage of 3-3.5X Debt:EBITDA. Assuming they continue to finance their investments with 45% debt, anything new must have an EBITDA multiple (i.e. cost of investment divided by EBITDA) of no higher than 7X. 3.25 leverage (the midpoint of their 3-3.5 range) divided by 45% debt share of finance is 7.2, which equates to around 14% (1 divided by 7.2), the midpoint of the required return we calculated based on their WACC.

The 55/45 ratio between equity and debt could be unsustainable if EBITDA falls. For example, a manageable 4X Debt:EBITDA leverage ratio would become an unsustainable 8X if EBITDA later dropped by half. Building in the possibility of lower tariffs in the future means debt should be less than 45% of the capital, which raises the WACC since equity is more expensive.

It’s also why you want to own strategic assets that don’t face huge drop-offs in revenues after initial contracts expire.

The flaw in PAA’s math can be illustrated by showing that they’d be willing to raise capital at today’s cost to buy an identical enterprise to their own, with identical EBITDA. Using their own cost of capital and 2019 EBITDA, they’d value this twin at over $33BN. Adjusting for debt, the twin’s equity would be worth $24BN, compared with PAA’s current market cap of only $17BN. Their math allows that PAA could pay up to a 39% premium to buy a business identical to what they own before the acquisition would no longer be accretive.

This is why investors are usually unenthusiastic when management teams announce another growth project. PAA, like most of its peers, should be more willing to repurchase shares.

The stock’s poor performance over the past five years is due to poor capital allocation decisions, probably driven by faulty logic such as described here.

No sell-side analyst pointed this out, but the shareholders who have lived it understand the flaws in PAA’ internal investment process.

Meanwhile, PAA is a cheap stock, trading at just 8X cash flows that are growing, assuming management is more prudent with investors’ money than over the past five years. The industry’s fortunes will turn on correctly calculating the spread between cost of, versus the return on, invested capital.

We are invested in PAA, via Plains GP Holdings.

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).

Miscounting America’s Crude

Wednesday’s report on crude oil stocks from the Energy Information Administration (EIA) showed a sharp jump in storage of 1 million barrels per day (MMB/D). Given the already fragile mood around tariffs slowing GDP growth, crude oil prices predictably slumped.

Interestingly though, over the past year the “Adjustment”, or fudge factor which is used to make the numbers add up, has grown substantially.

In simple terms, the EIA counts production, exports, imports, change in storage and refinery usage. This should pick up every barrel of oil moving through the U.S. It must frustrate the EIA’s number crunchers that the figures never foot, so they use a balancing item which used to be called “Unaccounted for Crude Oil”, nowadays simply the Adjustment. Since June 2018, the Adjustment has almost tripled.

Over the past year, crude oil used by U.S. refineries has been stable. Because much of America’s increased production is light crude from the Permian ill-suited to domestic refineries, imports have also remained unchanged. Higher exports have absorbed most of the increase in output.

The Adjustment exists solely because one of the other figures is wrong. So we’re refining more, exporting more, importing less, storing less or producing more than reported. Of these five different items, some should be easier to measure than others. The refinery figure seems unlikely to be far wrong; refineries must know what they’re using and there are 135 refineries in the U.S. from which to gather information.

Similarly, imports must surely be correct since the government licenses imports, and counting exports would also seem reasonably straightforward – the number of points of exports (cross-border pipelines and crude-loading export facilities) are known and not that numerous.

However, in reviewing the EIA’s methodology for calculating exports, they rely heavily on data from the U.S. Customs Border Protection (CBP) as well as figures from Statistics Canada (since exports to Canada don’t require a U.S. export license). The EIA runs the data through estimation models that they believe improve its accuracy. In some cases they’re using monthly data, even though their report is weekly.

There are many types of petroleum product beyond crude oil, including finished motor gasoline, kerosene, distillate and residual fuel oil among others. And the granting of an export license need not coincide with the physical shipment of the product. So it’s a more complex task than you might suppose.

Storage would also seem straightforward. Storage terminals are hard to miss. So the 967 thousand barrels per day (MB/D) build in storage ought to be reliable. Since the prior week saw a 41 MB/D decrease in storage, crude traders inferred softening demand.

But storage has its own complexity, since crude oil sitting on a tanker awaiting unloading is, in effect, floating storage. A possibility suggested by one sell-side firm is that floating storage was drawn down sharply. This presumes that several million barrels of crude was in tankers bobbing within U.S. territorial waters, already counted as imported but not yet unloaded. If true, this would mean the apparent jump in onshore storage was offset by a drawdown in floating storage, making the report far less bearish.

While this could explain the sudden, one-time shift in the storage figure, the Adjustment was the same last week, which undercuts the logic behind this explanation.

This brings us back to production, currently estimated at 12.4 MMB/D. Of the line items in the EIA’s report, it seems to us that this one is most plausibly the source of the growing Adjustment. There are around a million wells in the U.S. producing crude oil, from some decades old dribbling out a few barrels a day to new Permian wells producing 10 MB/D or more. We think it’s likely that the EIA is somehow undercounting crude oil output.

Flaring of associated natural gas in the Permian recently hit 661 million cubic feet per day (MMCF/D), up sharply from the previous high late last year of 450 MMCF/D. This reflects growing crude oil production. The continued shortage of take away infrastructure in the region to handle the natural gas that is extracted with the crude oil is why there’s more flaring.

Nobody really knows why the EIA’s weekly report includes an error term that is growing embarrassingly large. Robert Merriam, director of the office of petroleum and biofuels statistics at the EIA, admitted, “There’s something more systematic going on that our surveys aren’t capturing. We have some theories on what that may be and we’re trying to look into it.”

Undercounting crude oil production seems the most likely explanation. If so, this would reinforce a couple of important themes:

1) The U.S. continues to gain market share in world energy markets

2) Growing volumes even with moderate pricing defy those who argue that much of our shale activity is unprofitable

Oil and gas production continue to surprise to the upside, which can only be good for midstream energy infrastructure.

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 Moving Up and Left: More Return With Less Risk

The Capital Asset Pricing Model (CAPM) is a widely accepted theoretical framework for valuing securities. An important feature is the Efficient Frontier. This reflects the concept that, although there’s an almost infinite number of portfolios that an investor can hold (think of all the individual stocks and bonds out there), a small number of these portfolios offer a combination of return and risk that’s better than most.

Efficient Frontier

For example, if two portfolios had the same risk, the one with the higher return would be preferable. We can always figure out with hindsight what was the efficient portfolio — identifying the right one going forward is more difficult.

CAPM is a useful theoretical framework but has its shortcomings. One of the biggest is the idea that more risky investments deliver a higher return. It seems intuitively self-evident, but there’s plenty of research to show it’s not true. Beta, a measure of how risky a stock is compared to the market (which has a Beta of 1.0), suggests that high beta stocks (Beta > 1.0) should deliver higher returns than the market. Otherwise, investors wouldn’t own high beta stocks because they wouldn’t be getting sufficiently compensated for the increased risk.

The real world often fails to conform to neat algebraic solutions, and it turns out that low beta stocks do better. They don’t move as much and offer less excitement. Low Beta stocks receive less coverage on CNBC, since traders want movement. But they are Aesop’s tortoise, reaching the finish line ahead of their more energetic competition.

This weakness in CAPM is called the Low Beta Anomaly, and for those interested in learning more you can read Why the Tortoise Beats the Hare.

Returning to the Efficient Frontier, although we can’t be certain what investments provide the most CAPM efficiency, we can make informed assumptions about whether they’re becoming more or less attractive within this framework. Investors complain about heightened volatility in midstream, and likely assume more of the same in assessing the sector. For many, Energy infrastructure sits well within the Efficient Frontier boundary, making it unattractive.

Investor Perspective of Pipeline Sector

But Energy Infrastructure, as we wrote last week (see Pipeline Stocks Get That Warm Feeling Again), is becoming less volatile, especially when compared with broad energy as represented by the S&P Energy ETF (XLE). On the Efficient Frontier chart, this is moving it to the left, meaning it’s becoming less risky.

Returns are also improving, as defined by Free Cash Flow (FCF) generation. We wrote about this a few weeks ago (see The Coming Pipeline Cash Gusher). The members of the broad-based American Energy Independence Index generated just $1BN in FCF last year, which is an inconsequential return on around $540BN in market cap. However, a combination of lower spending on new projects (lower growth capex) plus improving cash flow from existing assets (higher Distributable Cash Flow, DCF) is set to boost sector FCF significantly over the next three years. By 2021 the $45BN in FCF we estimate would produce a FCF yield of over 8%, higher than the S&P500.

Pipeline Sector Free Cash Flow

Making volatility forecasts is an imprecise task, and most investors will be satisfied with using historical data. This shows decreasing volatility, or risk. But it’s certainly possible to make return forecasts and they don’t need to have any relationship with recent history. Rising FCF should persuade investors that their return assumption for the sector can be revised up.

In the context of CAPM, higher return with less risk mean that the sector is shifting up and to the left, making it more attractive. The Efficient Frontier is a theoretical concept, and investments selected from along that line can all be judged efficient, with the different combination of return and risk reflecting investor preference.

Improving Return and Risk

As this virtuous combination of rising return with falling volatility becomes apparent, we think some investors will conclude that midstream energy infrastructure lies beyond the Efficient Frontier. This should attract inflows from investors who use this type of framework to assess opportunities.

When CAPM provides a buy signal, the much-sought generalist investor will have finally turned to pipelines. Over the next couple of years, the sector should benefit from this development.

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).

Pipeline Stocks Get That Warm Feeling Again

A common concern of both existing and potential investors in energy infrastructure is the relatively high volatility of recent years. Many recall the “toll-model” of pipelines that was the basis of their appeal prior to 2014. As we have often written, the Shale Revolution broke the MLP model, as companies with very high payout ratios and hitherto minimal growth projects set about adding infrastructure. Oil in North Dakota, natural gas in Pennsylvania and increasing volumes of crude in west Texas required new investments (see It’s the Distributions, Stupid). The income-seeking investors originally attracted by high yields wound up in growth businesses that prioritized reducing leverage and funding projects over maintaining distributions.

Our theory is that this one-time alienation of the core investor base was highly disruptive and led to a period of heightened volatility. The shift in MLP business model from income generating to growth coincided with a sharp downturn in the energy sector. Investors worried about the profitability of upstream exploration and production companies showed similar concern over midstream. Even though EBITDA grew and leverage fell for pipeline stocks during this period, the sector moved with the energy sector.

There are signs that this period of heightened volatility is coming to a close. When energy markets bottomed in early 2016, the average daily percentage move of the Alerian MLP index reached almost 2.0X that of the S&P Energy Sector ETF (XLE). In late 2017 the ratio was briefly even higher. Since then, this relationship has improved dramatically in favor of these toll-like business models, falling by more than half and approaching the range that prevailed 7+ years ago.

This shift is even more dramatic than it seems, because the Alerian MLP index has been steadily losing components, rendering it less diversified and therefore more prone to sharp moves than it would otherwise be. Investors continue to exit mutual funds and ETFs tied to MLPs, as shown by the steady drop in shares outstanding for the Alerian MLP ETF.

Pipelines Beating SP500

Nonetheless, relative performance for the sector more broadly defined to include corporations has held up very well. The American Energy Independence Index (80% corporations and 20% MLPs, more reflective of the sector’s market cap of 2/3rds corporations) has retained its solid lead over the S&P500 this year, and is substantially ahead of XLE, especially following last week’s market weakness.

Midstream beating XLE

A plausible explanation is that, although retail investors are shunning MLP-only funds, institutional buyers are beginning to commit capital to pipeline corporations. Converting from MLPs to corporations was driven by a desire for a broader, more stable investor base. Although there are fewer MLPs remaining, they include conservatively run companies such as Enterprise Products Partners (EPD) and Magellan Midstream (MMP). There are some good MLPs to own.  However, some investors are starting to conclude that MLPs are too small a subset to command a sector allocation, and they’re more appropriate within a diversified portfolio that includes corporations.

Retail Investors selling MLPs

The relative volatility of midstream infrastructure is reverting back to the lower levels that prevailed before the Shale Revolution triggered the need for large infrastructure investments. Moreover, free cash flow is set to jump over the next three years (see The Coming Pipeline Cash Gusher). This will continue to attract generalist investors interested in attractively valued stocks with declining volatility.

The pipeline sector is showing good momentum to continue its outperformance, driven by institutional buyers gradually replacing the retail holders of narrow, MLP-only funds.

We are invested in EPD and MMP. 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).

Better Odds With Pipelines

The mood at the 2019 Midstream Energy Infrastructure Conference was noticeably more positive than in the past couple of years. Perhaps relocating from Orlando to Las Vegas helped. Hope for positive financial outcomes is in the local DNA, and pipeline investors could smugly remind themselves that the best odds were not in the casino. Attendance seemed to be higher than in the recent past, and demand for one-on-one meetings with management teams (the point of attending for many, including ourselves) was reportedly up sharply.

Investors keep pounding away on planned growth capex, and companies are generally responding by guiding to less spending this year and next while still emphasizing their slate of attractive opportunities. We checked our assumptions underlying The Coming Pipeline Cash Gusher in several meetings and still see a substantial jump in industry free cash flow over the next three years.

 

 

Henry & Simon MEIC

 

 

New pipelines are becoming harder to build. New York recently blocked a natural gas pipeline planned by Williams Companies (WMB) because of environmental concerns, although WMB plans to reapply. Canada is becoming a more difficult and expensive place in which to build (other than in oil-rich Alberta). Enbridge (ENB) went as far as to say they wouldn’t attempt a new, greenfield crude oil pipeline in Canada. They regard the permitting process as capricious, hijacked by a small minority of vocal environmental activists that don’t reflect the public interest.

Impeding new construction simply increases the value of the existing asset base. It also means that today’s dominant firms will maintain their market positions in the future; this is not an industry where a disruptive start-up has realistic prospects.

It also creates an unusual alignment of interests between anti-fossil fuel, environmental activists and investors who are clamoring for a greater return of cash to owners. Both are opposed to new spending, albeit for different reasons.

Tellurian (TELL) is developing a Liquified Natural Gas (LNG) export complex. Their unusual financing model involves raising equity capital from customers. In this way they share some of the project’s upside and create key long term partnerships. They see growing Permian crude production leading to a huge jump in associated natural gas output, creating the need for an additional 20 Billion Cubic Feet per day (BCF/D) of LNG export capacity.

Incidentally, in a panel on LNG, Andy Orekar of Gaslog Partners said that if all the world’s shipping converted to LNG (because of the impending IMO 2020 standards on maritime emissions) it would consume more than all of the current trade in LNG. Currently, gas-powered ships are limited to LNG tankers that consume a small portion of their cargo for power. It’s a theoretical point since the industry is installing sulfur scrubbers and switching to cleaner crude oil-based fuels, but an interesting one nonetheless.

Today the U.S. exports around 4 BCF/D. Because natural gas is an inevitable byproduct of crude production in the Permian, TELL expects the economics of oil to drive more gas output which will need to be sent somewhere. They believe the Permian may produce as much as 30BCF/D, creating a need for almost all proposed LNG projects. Increased domestic consumption and pipeline exports to Mexico will only soak up so much, with seaborne LNG exports being critical to avoid constraints on crude production. Flaring unwanted natural gas is limited, and the larger companies that are now dominating Permian activity are especially likely to avoid the negative publicity associated with such obvious waste.

Private equity has developed into an alternative source of financing for midstream infrastructure since public market valuations essentially render equity financing prohibitive. This highlights the contrast between how public and private markets view the sector. Although private funds can compete effectively for projects, it’s also made exits harder, leading to longer holding periods that can reduce returns. The traditional arbitrage, in which public buyers acquire assets at higher multiples than paid by private equity, is currently being reversed. This reflects the continued public market wariness of midstream energy infrastructure, and highlights currently attractive valuations.

Most firms now have a set of policies covering ESG (Environmental, Social and Governance). This is regarded by some as a requirement for drawing in generalist investor interest. One company noted that European investors were more likely to use ESG as a screening metric, and reported that they had seen a notable pick up in interest from non-traditional investors in response to their adopting ESG policies. Mentioning Energy Transfer (ET) in the context of ESG invariably draws a chuckle (see Why Energy Transfer Can’t Get Respect)

A meeting with Enterprise Products Partners (EPD) produced some useful insights. They regard U.S. crude oil export infrastructure as still catching up with volumes. Building a facility to accommodate Very Large Crude Carriers (VLCC) is an important objective for them. The application to build this terminal was 13,000 pages and weighed 100 lbs.

EPD also sees very strong Chinese demand for U.S. exports of ethane and propane, with the current trade dispute not regarded as a long-term problem.

The “War on Plastics” led them to point out the slide shown below, which highlights how much of global plastics pollution can be traced back to ineffective disposal among some Asian countries.

Poor Plastics Disposal

Overall, the news was good and growing free cash flows are beginning to draw interest from a wider pool of investors. We left with reinforced conviction that valuations are excessively pessimistic. Strong returns lie ahead.

We are invested in ENB, EPD, ET, TELL and 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).

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