SL Advisors Talks Markets

AMLP Has Yet More Tax Problems

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 30 seconds

00:00 / 00:05:34

RSS Feed

Share

Link

Embed

Last November SS&C Alps Advisors, the people who manage the Alerian MLP ETF (AMLP), admitted that they’d screwed up calculating the taxes owed by their fund. Mutual funds and ETFs don’t pay taxes as long as they comply with the rules of the 1940 Investment Company Act for an exemption. AMLP does not comply, because it invests in Master Limited Partnerships (MLPs). Owning more than 25% renders a fund non-RIC compliant and therefore liable for taxes like any other American company. AMLP is 100% MLPs.

We have written tirelessly on the topic (see MLP Funds Made for Uncle Sam). Last December we noted AMLP’s reduced NAV (see AMLP Trips Up On Tax Complexity) which fell 3.9% at their November fiscal year-end. Because of its flawed structure concentrated on MLPs and thereby liable for corporate taxes, AMLP has a five year annual return of 4.97%. The Alerian MLP Index, which it seeks to track, has returned 7.42%. The 2.45% difference is partly AMLP’s 0.85% annual management fee, but mostly the burden of taxes. By contrast, the investible American Energy Independence Index (AEITR) has a five year return of 11.06%.

Nobody would create AMLP today. MLPs are around a third of the sector, and their numbers continue to decline. It is a relic of a decade ago when the MLP structure dominated. That is no longer the case.

Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) a couple of weeks ago caused smaller MLPs to briefly catch a bid as traders calculated the rebalancing within a shrinking pool the loss of MMP would cause for AMLP. The OKE-MMP transaction is looking less likely, as explained later in this blog post.

Nonetheless, AMLP is still the sector’s biggest ETF by a considerable margin. That AMLP retains any holders is confirmation that inertia and benign tolerance still inform investment decisions for some.

November’s tax-based NAV correction wasn’t the advisor’s last word on the issue. Last week they provided a tax update that, “modified the estimate of the Fund’s deferred tax liability” by $188 million, an additional 2.27%.

This will push AMLP’s five year underperformance against an index that has itself severely lagged midstream energy infrastructure to close to 3%.

Since November, AMLP’s NAV has been adjusted down by over 6% as Alps hopes it has finally got its arms around the complex tax issues the fund faces. Their lawyers, who will have carefully drafted the latest press release, wisely added, “The Fund’s estimates regarding its deferred tax liability are made in good faith; however, the daily estimate of the Fund’s deferred tax liability used to calculate the Fund’s NAV could vary significantly from the Fund’s actual tax liability.”

In other words, there could be more to come.

There must exist a hardcore group of AMLP investors who resemble the reliable and extreme primary voters of either political party. They accept their flawed choice with no regard for continued evidence of his (her) failings, because to change now would mean conceding an earlier error. There is no helping these investors. They fork over $50 million in management fees annually to an advisor who has now made two tax errors equal to multiples of that.

But there also exists a swathe of financial advisors holding AMLP for clients whose fiduciary fitness can be questioned by having selected such a poorly run, anachronistic fund. You may be one of these advisors, or you may be a client of one. $405 million of tax-related restatements is starting to look like a situation best avoided. Perhaps a class action lawsuit will seek to restore some of those losses out of past management fees.

AMLP now reports a Deferred Tax Liability (DTL) of $373 million (as of June 2, 2023). Market appreciation will create additional unrealized gains and an increased DTL, which will act as a headwind in a rising market.

The case for not owning AMLP could not be clearer. In fact, its best use may be as a short position, as we’ve noted in the past (see Uncle Sam Helps You Short AMLP).

Investors in OKE and MMP will be encouraged to see a widening spread between MMP’s price and the value of OKE’s proposed acquisition. This means traders are increasingly skeptical that the deal will get done. Since the announcement on May 12, OKE is down 8% and MMP is up only 11%, half the promised premium. The AEITR is +2.5%. It’s one of those rare transactions that is bad for both sides (see Oneok Does A Deal Nobody Needs). OKE gets higher leverage and MMP investors face an unwelcome tax bill.

Hopefully it’ll get voted down. We calculate the market-implied odds of it going through are now barely above 50/50*.

We have three funds that seek to profit from this environment:

*The probability of the deal happening is estimated as follows:

Let:

MMP = current price of MMP

MMPD = price of MMP implied by deal

MMPND – the price MMP would drop to if the deal was canceled, which is assumed to be its pre-deal level adjusted for subsequent move in sector as defined by AEITR.

Deal Probability, or DP = (MMPD-MMP)/(MMP-MMPND)

Therefore, odds of No Deal = 1-DP

SL Advisors Talks Markets

The 2023 MEIC Conference

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 30 seconds

00:00 / 00:08:51

RSS Feed

Share

Link

Embed

Last week the Midstream Energy Infrastructure Conference (MEIC) held its annual event in Palm Beach, FL. SL Advisors partner Henry Hoffman was there and today’s blog post recounts highlights reported by Henry.  

Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) was a common topic, especially the unwelcome recapture of deferred taxes facing MMP. When a c-corp, in this case OKE, buys a partnership (MMP), the limited partners in the target get a bad tax outcome. 

For this reason, Crestwood, LP CEO Bob Phillips told us they’d never sell to a c-corp buyer. Since he’s never sold a unit of CEQP, his recapture of deferred taxes would presumably be significant. Williams CEO Alan Armstrong recalled paying a hefty tax bill on his own holdings of Williams Partners, LP when it was acquired by the parent company in 2018. There are few painless exits from an MLP investment. 

One sell-side analyst reported that MMP had decided to sell because they didn’t see an obvious path to growth short of significant capex, and believed their company was undervalued. Overall companies expressed predictable interest in making bolt-on acquisitions but there was little indication of any other large deals in the works.  

Gabe Moreen of Mizuho Securities, Adam Breit, from Truist and Chase Mulvehill from Bank of America generally agreed that strong balance sheets would allow further industry consolidation but were skeptical about any other large deals like OKE-MMP.  

 Natural gas takeaway infrastructure and permitting reform were two themes that recurred in discussions. Lunch speaker Dan Reicher, former Assistant Secretary for Energy (1997-2001), brought attention to the issue of consistent underinvestment in public infrastructure, particularly in areas that don’t provide immediate private returns. He underlined the criticality of bipartisan dialogue and collaboration in addressing the complex challenges of the energy sector.  

A panel discussion covered potential opportunities for private equity deals, the escalating need for gas takeaway capacity, and the evolution of energy project permitting in the light of increasing social justice focus. J.P. Morgan’s financing panel predicted a challenging environment for upstream financing but expressed optimism for the LNG debt sector noting that financing has continued unabated. 

Another lunch speaker, Dr. Amrita Sen from Energy Aspects, highlighted the robust Asian demand for Liquified Natural Gas (LNG) and the global increase in Natural Gas Liquids (NGL) demand. She noted the persistent underinvestment in the supply of both LNG and NGLs. 

Highlights from interactions with individual companies are below: 

In a fireside chat, Enterprise Products Partners (EPD) Co-CEO, Randy Fowler, shared his perspectives on acquisitions. Fowler emphasized the importance of quality in three main areas: contracts; the producers underpinning those contracts; and the quality of systems in which these contracts operate. Specifically, he cited the Navitas acquisition as an example.  Fowler also reflected on the company’s response to the COVID-19 pandemic. He noted that most staff returned to office work within 2-3 weeks, with the exception of immunocompromised individuals. He made it clear that remote work was not an option for their field workers and office workers should share the same ethos.   

In a separate panel discussion on the topic of ESG, Fowler pointed out that with 30% of the world’s population living in energy poverty, EPD’s export of propane is making a tangible difference in people’s lives. He noted that EPD exports more propane than Saudi Arabia, a statistic that underscores the scale of their operations. He highlighted the fact that more people die annually from unsafe cooking practices than did from COVID-19 during the peak of the pandemic, emphasizing the vital role of liquefied petroleum gas in addressing this issue. He described LPGs from shale as a ‘true miracle.’  

EPD also reiterated their commitment to the Master Limited Partnership structure. 

Energy Transfer’s (ET) CFO, Dylan Bramhall, provided an update on the regulatory challenges the company is facing. He expressed shock at the Department of Energy’s denial of a permit extension for the Lake Charles LNG project. ET is appealing the decision, the results of which are expected within a month. Bramhall cautioned that this development may signal a shift towards more regulatory activism, potentially introducing a new layer of uncertainty and complexity in securing project financing.  

Bramhall revealed plans to share financing responsibilities for Lake Charles with the individual equity partners rather than at the project level, with ET retaining a long-term 25% stake in the project. He highlighted the financial flexibility of the company and pointed out potential upstream synergies of Lake Charles. Bramhall also shared an ambition for more mergers and acquisitions, ideally financed through cash reserves expected to accumulate after a predicted upgrade to their credit rating later this year. 

Jesse Arenivas, CEO of Enlink, concentrated our group session on the company’s Carbon Capture and Sequestration (CCS) initiatives. He projected that this business would represent 25% of the company’s EBITDA by 2030. Arenivas conceded that weather conditions had negatively impacted the company’s Q1 performance but remained optimistic about Enlink’s future prospects. He suggested that the company’s current market undervaluation makes acquisitions unattractive, effectively eliminating any M&A concerns. 

Breck Bash with CapturePoint, a Texas energy distribution company, also reported seeing huge opportunities in CCS especially after the passage of the Inflation Reduction Act which includes substantial tax credits. 

Alan Armstrong, CEO of Williams Companies, stressed that strong demand for the company’s services is challenging their capacity to deliver. With a long list of promising organic projects in the pipeline, Armstrong suggested that the company is not presently interested in pursuing M&A strategies. He drew attention to the Supreme Court hearing on the Chevron Deference case, indicating that its outcome could have considerable implications for the permitting process in the energy sector.  

Nearly 40 years ago, in Chevron v. Natural Resources Defense Council, the US Supreme Court ruled that courts should defer to a federal agency’s interpretation of an ambiguous statute as long as that interpretation is reasonable. The Supreme Court has agreed to reconsider that ruling.  

In a highly engaging conversation, Targa’s CEO, Matthew Meloy detailed his strategic approach to capital allocation. He highlighted his willingness to buy back his stock at a 7X EV/EBITDA multiple while identifying low-risk investment opportunities in contracted projects at a 4X multiple. Meloy offered insights into the potential sale of non-core assets in South Texas and the Badlands, which require minimal capex and yield stable cash flows. Meloy’s ten-year NPV approach to Targa and its assets displayed a keen sense of value. While he currently sees numerous opportunities, he acknowledged a potential surplus of free cash flow versus investment opportunities in the next 3-5 years. Consequently, Meloy expects a substantial increase in dividend payments in the future, although not near-term. 

Lastly, Tellurian is optimistic about their prospects for securing equity partners by the end of July for their LNG project. They estimated that bank debt would be finalized within two months following the equity financing deal. Despite skepticism in the market, they argued that successfully securing equity financing would significantly boost their stock value. We have been critics of Tellurian, because of CEO Souki’s excessive compensation and a business model that until recently retained natural gas price risk in their LNG contracts which has made achieving financing more challenging.  

Overall attendance at the 2023 MEIC was reported as similar to last year. One analyst was surprised it wasn’t greater given the frequent positive conversations he’s having with investors. 

We found that it confirmed our bullish outlook, based on strong balance sheets, continuing capital discipline and continued global demand growth for US gas, NGLs and crude oil.  

We have three funds that seek to profit from this environment:

SL Advisors Talks Markets

More Thoughts On Oneok and Magellan

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 30 seconds

00:00 / 00:04:56

RSS Feed

Share

Link

Embed

Wall Street analysts are predisposed to be supportive of management’s M&A activities.  The sycophantic posturing that precedes an earnings call question with, “Nice quarter, guys” lives in the hope of investment banking business. Hence the response of sell-side analysts to Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) is one of mild surprise at this unlikely combination that stops short of overt criticism.

The numbers offer a less enthusiastic reception. OKE is –8% since the deal was announced, in spite of the $1.5BN tax shield and $200-400MM of annual synergies. MMP is up 13%, but this is well short of the 22% premium that heralded the deal because of OKE’s underperformance. In addition, MMP investors are facing the recapture of deferred taxes on prior distributions. This will be more for long term holders, which runs counter to the point of MLPs which is to allow long term management of tax deferrals by investors.

It’s hard to see anyone other than a recent MMP investor being untroubled by the recapture. The cohort of long term MMP holders may be too small for their votes to disrupt the deal. MMP has presumably analyzed this closely. But financial advisors who hold MMP in client accounts will not relish explaining any unexpected tax bill to clients.

An investor who owned OKE and MMP in proportion to their relative market caps is down 2.2%. By contrast, the Alerian MLP Index (AMZX) has gained 4.8% since the deal, partly due to MMP’s jump but also because traders have anticipated a rebalancing from MMP once it disappears into the shrinking group of remaining MLPs. In other words, the investors who have done best out of this deal are the ones not involved in it.

If the transaction ultimately closes, enthusiasm will be muted. The proposed OKE acquisition of MMP is a solution to a problem nobody has.

Turning to the regional bank crisis — a few weeks ago I shared my experience as treasurer of our Naples co-op in trying to earn a fair interest rate on our cash (see Some Banks Are Having To Pay More). We recently switched banks and left the 3% deposit rate that we had only achieved through persistent complaints. Banks operate on the assumption that you don’t know where treasury bills or Fed Funds are.

Our new bank relationship began at 0.25%. The initial response when I requested a competitive rate was that I should point out a competitor’s rate and they would then consider the matter. I responded that 0.25% was so off-market that it was unworthy of such effort and that they were insulting my intelligence. Days passed with no response, and finally they improved to 2%. This is from a bank whose market cap has shed two thirds in the past eighteen months.

So we’re going to open a brokerage account and buy treasury bills which yield 5%. It creates some additional administrative work, but such offensive behavior demands it. This is how one regional bank will lose a $500K deposit. Banks behave as if we’re stupid, or lazy. Their prior experience may justify such a stance, but it hardly seems like a stable business model to hold your customers in such low regard.

The question regional bank investors must answer is whether large numbers of depositors will react like us. Banking services need to be paid for. Banks rely on paying a discounted rate on deposits. The last time Fed funds traded above 2.5% was in 2008 before the Great Financial Crisis (GFC). Since then, deposit rates near zero haven’t represented much of an opportunity cost for customers.

Now they do, and in the intervening fifteen years moving money and gaining access to information have only become easier. Banks don’t seem willing to create linked brokerage accounts that can own treasury bills, and information about deposit rates for business clients is kept intentionally opaque. They don’t make it easy.

Nonetheless, foregoing a couple of per cent on $250K might strike many depositors as a steep price to pay for banking services.

If competitive pressure forces deposit rates higher, net interest margins will be squeezed. The argument against marking to market bank holdings of securities rests on the notion that deposits are sticky and when rates are rising the value of that stickiness (ie the discount to treasury bill yields) increases. But this is based on past behavior. How depositors reacted to rising rates prior to the GFC may not be a useful guide today. Deposits can leave, at times quickly. Regional bank investors will find out in the months ahead how responsive savers are to more competitive rates from the US Treasury.

We have three funds that seek to profit from this environment:

SL Advisors Talks Markets

4% Inflation Is Our Least Bad Option

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 30 seconds

00:00 / 00:05:05

RSS Feed

Share

Link

Embed

Last week the WSJ warned that We May Be Getting Used To High Inflation. Only 9% of respondents in a recent survey think inflation is our most important problem. Government leadership (presumably the absence thereof) and “the economy in general” were both bigger concerns.

Americans are learning to live with higher inflation. The University of Michigan shows that one year inflation expectations among consumers have been rising all year. The Employment Cost Index is increasing at 5%, a figure generally felt to be inconsistent with 2% inflation. The Fed’s preferred Personal Consumption Expenditures (PCE) deflator has been above 3% for two years. These are all signs that households and businesses are adapting to a world of 3-4% inflation, not 2%.

The bond market tells a different story. The spread between ten year treasury notes and TIPs implies investors expect CPI to average around 2.3% over the next decade. By this measure, markets have never been that worried about persistent inflation. It’s remained below 2.5% for most of the past year.

TIPs ought to be a reliable indicator, because return-seeking bond buyers are presumably putting considerable thought into their purchases. But to this observer it looks likely that years of Quantitative Easing (QE) along with $TNs held by foreign central banks (China; Japan) and others who want returnless liquidity have distorted the message bonds would otherwise communicate. Bonds are a broken indicator.

WSJ writer Greg Ip thinks Americans getting used to higher inflation “very bad news”. He’s right if the Federal Reserve regards embedded inflation expectations as in need of further monetary attention. But it’s not clear that 3% or 4% inflation is worse for real GDP growth than 2%.

Since 1990, five year trailing CPI inflation has ranged from 2-4% and had been slowly declining until the pandemic-induced jump. There is no statistical relationship with real GDP growth. That doesn’t mean that inflation doesn’t matter, but the data shows that if it’s relatively stable 2% isn’t any better than 4%. Central bankers have made 2% a religious tenet. It’s really a shibboleth.

Raising the debt ceiling will soon become the biggest concern of market participants, since negotiations look likely to reach or even pass the deadline. A rare flaw in the US constitution separates spending decisions from financing ones – Congress ought to raise the debt ceiling whenever they approve a budget. The debt ceiling standoff is what passes for serious consideration of America’s fiscal outlook in Washington, so every couple of years we wonder whether this game of chicken will go wrong. US credit default swap spreads are wider than Greece.

Our projected indebtedness is familiar with no solution in sight. The deficit barely registers as an issue. Politicians who suggest raising taxes or cutting spending soon get dumped by voters and move on to the more lucrative business of lobbying.

The Fed deserves their share of blame. Fifteen years of QE has held bond yields down, muting whatever warning of fiscal profligacy higher yields might otherwise transmit.

More recently, higher interest rates have brought various terrible milestones closer by two to three years (see How Tightening Impacts Our Fiscal Outlook). The February 2023 edition of The Budget and Economic Outlook, published by the Congressional Budget Office, was updated for the Fed’s tighter monetary policy compared with the previous publication in May 2022. Debt:GDP will now cross 100% in 2024 rather than 2027. Annual interest expense will reach $1TN in 2028 not 2030.

Inflation is the friend of the inveterate borrower. It reduces the real value of obligations. Our fiscal outlook will benefit if debt growth lags nominal GDP. Low interest rates, especially negative real rates, help. 4% inflation leaves more room for real yields to be negative. 2% doesn’t, and as we’re seeing the effort to get inflation back to 2% is making our fiscal outlook worse.

Throughout history governments have eased their debt burden through currency debasement. I explained why this will be America’s solution a decade ago in Bonds Are Not Forever. Developments since then confirm this outlook. There’s little reason to expect spending cuts or tax hikes because there are no votes in it and no apparent cost to current policies. Today’s biggest economic disruption is coming from the Fed’s efforts to restore inflation to 2%. Regional banks and the Federal government need lower rates. There’s a fiscal cost to tight monetary policy.

We can lower inflation or our debt burden. We can’t do both. They are mutually incompatible objectives. We are already learning to live with 4% inflation. It’s not that bad. It’s the path of least resistance.

We have three funds that seek to profit from this environment:

SL Advisors Talks Markets

Why Keep Money At A Bank?

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 30 seconds

00:00 / 00:06:04

RSS Feed

Share

Link

Embed

I looked through First Horizon Bank’s (FHN) 10K last week. They were in the news because Toronto Dominion (TD) canceled their merger agreement due to uncertainty about when they might receive regulatory approval. FHN’s stock slumped to below $10. The merger price, agreed in February of last year, was $25.

FHN CEO Bryan Jordan told CNBC that he had never been able to ascertain from TD the precise nature of the regulatory impediment that TD was facing. Nonetheless TD had second thoughts and regarded the $200 million break-up fee as better business than paying $13.45BN for a bank whose market cap is now less than half that.

FHN reported $1,159 million in pre-tax income last year, down modestly from 2021’s figure of $1,284 million. This excludes unrealized losses on their securities portfolio and hedges of $1,080 million, reported under Other Comprehensive Income. Including them would have wiped out the whole year’s profit. Perhaps this convinced TD to walk away.

When interest rates depress the value of bonds, banks don’t have to record unrealized losses as long as they have the intention and ability to hold them until maturity. Defenders of this approach argue that higher rates benefit the liability side of a bank’s balance sheet because deposit rates typically rise less than Fed Funds. Revaluing the assets and not the liabilities would present an inaccurate picture. However, it assumes the deposits won’t leave. Banks rely on history to assess the stickiness of their deposit base. Sometimes, as with Silicon Valley and First Republic, they’re wrong.

Deposits are sticky because savers are lazy or unsure how to access better rates using treasury bills. Banks are relying on this historic behavior repeating to fund their underwater bonds with uncompetitive deposit rates.

It costs money to provide banking services, and fees are highly unpopular. So in effect the fees are bundled into the service. Banks don’t pay much interest. That’s the fee.

Most of us weren’t watching while banks steadily loaded up on interest rate risk following the 2008 Great Financial Crisis (GFC). Quantitative Easing (QE) was intended to stimulate demand for capital by suppressing rates. But what’s good for borrowers can be bad for lenders. Many banks responded to low rates by increasing fixed rate commercial loans and mortgages. QE was supposed to encourage borrowing, but it also encouraged more long-term lending from banks.

FHN is a portfolio of underwater bonds and loans whose funding relies on uninformed depositors willing to leave money with them at low rates. Banks have always paid uncompetitive rates on savings. It’s part of the business model. It’s why banks traditionally do well when rates go up. FHN’s 10K shows that their Net Interest Margin (NIM) improves with higher rates. In 1Q23 earnings released on Thursday NIM deteriorated in spite of continued Fed tightening. And last year higher rates cost FHN over $1BN.

Like most banks, FHN assumes their deposits are unlikely to leave for higher rates elsewhere. But is that about to change? Silicon Valley caused people to ask two questions: (1) Is my money safe? (2) What interest is it earning?

The Fed has played a significant role in this. Because of QE investors and banks have faced unattractively low rates for years. The Fed was slow to recognize the risk of inflation. As a result, they raised rates faster than many expected. And they didn’t consider the impact on the banking system, which they regulate, of higher rates.

The Fed added to the pressure on regional banks by raising rates last week, further highlighting the uncompetitive rates paid on deposits. An increase in the FDIC cap above $250K would slow the outflow, but what banks really need is lower short term rates. Heavy reliance on large uninsured deposits isn’t every bank’s problem. But holdings of low fixed rate securities and loans are widespread.

America has over 4,000 banks. The figure has been declining for decades. We had twice that number in 1999. This abundance is a uniquely American construct, a legacy of state banking regulations which used to impede expansion. Often the small bank strategy was to be acquired by a bigger one. Today that’s only happening as a distressed sale. We’re learning that there aren’t 4,000 competent chief risk officers employed in the banking system.

Today, why would you deposit cash at First Horizon or indeed any bank beyond the amount you need to keep in a checking account? Fees are disguised as paltry rates on deposits. Banks have insulted our intelligence in this way for years. Rapid Fed tightening is illuminating it.

The market is priced for the Fed to provide banking relief in the form of lower rates, this year. The FOMC is in denial – slow as usual to comprehend what’s happening. The regional banking crisis won’t end until the Fed gets it. In the meantime, loan growth at all but the biggest institutions will be constrained by the risk of a rapid loss of deposits and recourse to wholesale funding in the Fed Funds market. Few banks can profitably fund their assets at 5%.

This is why you should bet on 4% inflation instead of 2%. It’s the path of least resistance.

We have three funds that seek to profit from this environment: