Last week was a busy week of earnings reports for many sectors, including energy infrastructure. Growing energy sector profitability is feeding through to higher returns to investors. Over the past month the S&P Energy Sector ETF (XLE) has outperformed the S&P by over 9%. RBN Energy has a good blog post (see Better – E&P Profits Appear Ready To Take Off This Year After Turning A Corner In 2017), highlighting that the 2017 impairments are unlikely to be repeated and that higher oil prices will drive improved operating margins.
Enterprise Products Partners (EPD) reported 1Q18 EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of almost $1.7BN, 11.5% ahead of consensus. That was a significant beat for such a large, stable business as every segment did better than expected. EPD has a premier position on the Gulf Coast and is a leading exporter of U.S petroleum liquids. On the call, CEO Jim Teague highlighted the value of midstream companies in getting product to the global market. “The name of the game for U.S. production is exports, exports, exports, exports, of crude oil, natural gas, ethane, LPG, petrochemicals and refined products.” Last year EPD trimmed its forecast distribution growth in order to redirect more cashflows into growth projects. Income seeking investors were underwhelmed, but it simply reflected EPD’s response to the changing MLP business model.
1Q18 earnings reported by Oneok (OKE) beat expectations by 4%, driven by strength in their Natural Gas Liquids segment in the SCOOP and STACK play in Oklahoma. Pembina (PPL) announced a 19% year-on-year dividend increase as their Veresen acquisition and assets recently placed into service powered EBITDA growth. Targa Resources (TRGP) reported a solid quarter and positive outlook. They are the leader in providing gathering and processing in the Permian Basin, but even more interesting was the volume growth they saw elsewhere, in North Dakota and South Texas. Tallgrass Energy Partners (TEP) reported on their earnings call increasing throughput on their Pony Express crude pipeline that links the Bakken in North Dakota to Cushing, OK. 1Q18 volumes averaged 290 thousand barrels per day (MB/D), up by 22MB/D on 4Q17, and are expected to reach 350MB/D this month. This shows that it’s not just Permian crude output that is growing, with U.S. production reaching 10.6MMB/D. Record earnings and volumes were reported by a good number of names.
Most dramatically, Cheniere Energy (LNG) announced consolidated EBITDA of $907MM, up 88% on a year ago and 46% ahead of expectations. They raised full year guidance by 14%. Surging demand for U.S. exports of Liquified Natural Gas underpin the outlook. Higher crude prices are also improving the competitive position of U.S. exports since global natural gas pricing is often linked to crude oil while U.S. domestic gas prices remain among the lowest in the world.
Energy infrastructure businesses do better when their customers are thriving. Growing oil and gas production is creating tightness in some of the support functions. We recently highlighted the Midland-Houston spread for crude oil, which should normally be limited by the $2-3 pipeline tariff to move crude from the Permian wellhead to customers on the Gulf Coast (see Dwindling Pipeline Capacity Causes FOMO). Limited pipeline capacity had caused the differential to increase to over $6, as producers were forced to utilize more expensive rail or truck transportation. Last week the spread reached $12, beyond the cost of rail transportation and therefore indicating greater use of trucks.
The losers are oil producers without contracted pipeline take-away capacity. The pipeline industry often complains about “freeloaders”; pipelines are built once enough capacity has been contracted out to meet required return thresholds. Oil and gas producers who don’t make those early commitments can still access the pipeline once it’s built. They benefit from the support of their peers who underwrote the infrastructure development. But when pipeline capacity is tight, these “walk-up” customers have to pay market rates, which rise. Plains All American (PAA) will announce earnings on Tuesday, and as the biggest crude oil pipeline operator in the Permian, their comments on demand for takeaway capacity will be especially interesting.
Not everything was good. Marathon Petroleum (MPC) acquired Andeavor, orphaning MLP Andeavor Logistics (ANDX). We highlighted in last week’s blog that corporate parent TransCanada (TRP) had said their MLP, TC Pipelines (TCP), was no longer viable as a funding vehicle, rendering them of little use to TRP. Subsequently, TCP slashed their distribution by 35%. The recent FERC ruling was the cause. Spectra Energy (SEP) and Enbridge Energy Partners (EEP) were similarly weak as investors contemplated their “orphan” status. One subscriber asked us if he should avoid MLPs entirely that have a separate General Partner (GP), given recent developments. As regular readers know, we only hold MLPs that have no GP, to avoid just the sort of issue faced by TCP investors.
Williams Companies (WMB) set new volume records for gas on its TransCo system, but offered little new regarding a potential combination with their MLP Williams Partners (WPZ). Their Analyst Day later this month is expected to offer an update. WPZ investors face the risk that a combination with WMB will trigger a tax bill for deferred income.
Broad energy infrastructure as defined by the American Energy Independence Index continues to outperform the narrower Alerian MLP Index (AMZ), a trend set in motion by the FERC ruling in March. AMZ remains below its pre-FERC announcement level. Although MLPs retain an important tax advantage over corporate ownership of energy infrastructure assets, the several dozen distribution cuts by MLPs since 2014, as well as unwelcome simplification transactions, have clearly soured their traditional investor base. MLPs are evolving towards more internally-financed growth, which is for now impeding distribution growth.
On Tuesday, we’ll be ringing the NYSE closing bell to celebrate the recent launch of our. Check us out on CNBC at 4pm.
We are invested in EPD, LNG, MPC, OKE, PPL, TRGP, TEGP (GP of TEP) and WMB
In recent weeks there’s been growing discussion about the future of MLPs (see Are MLPs Going Away?). Although the prospects for U.S. energy infrastructure are very good, the need for growth capital has exposed the limitations of the MLP investor base. Not everyone agrees. Stacey Morris of Alerian provided a thoughtful assessment (see Are MLPs Really Disappearing?), and concluded that MLPs would remain the dominant corporate form in the sector.
Two external factors weighing on sentiment have been tax reform and the FERC (Federal Energy Regulatory Commission) ruling. Tax reform’s impact was modest; a lower corporate tax rate reduces the competitive advantage of an MLP over a corporation, but the tax rate on recapture of income previously deferred was improved. The FERC ruling is potentially a long run problem for some businesses.
Although MLPs don’t pay tax, they had included taxes paid by their equity investors in calculating costs for certain contracts. It’s an odd concept, to include as an expense a cost you don’t incur, and a successful court challenge by United Airlines led to the change. The subsequent FERC announcement briefly led to a 10% drop in MLP prices on March 15th, highlighting confusion as well as the shallow conviction of some holders. While initially limited to certain interstate natural gas pipelines, it will in time also apply to other liquids lines. It’s narrow in scope but still a mild negative for a few names. It’s likely that the same assets held by a corporation rather than an MLP wouldn’t be as affected, which will cause some firms to consider changing their form of ownership.
We’re long-time MLP investors. While at JPMorgan, the private equity fund I ran seeded Alerian’s offshore MLP hedge fund in 2005. Tax-deferred, stable, high yields uncorrelated with commodity prices attracted many. The re-emergence of the U.S. as a significant energy producer changed that. Before the Shale Revolution, we consumed roughly the same quantities of energy from the same parts of the country every year. The need for new infrastructure was limited. Consequently, MLPs could pay out 90% or more of their Distributable Cash Flow (DCF) to the older, wealthy, K-1 tolerant investors who were the main buyers.
This financing model wasn’t able to support the need for growth capital to connect new sources of oil and gas with customers: crude oil from North Dakota; natural gas from Pennsylvania and Ohio; sharply increasing volumes of crude from the Permian Basin in west Texas. MLPs tried maintaining distributions while issuing increasing amounts of equity and debt, but it didn’t work. Kinder Morgan (KMI) went first in 2014, rolling up three public entities into their corporate parent, simplifying from four traded entities to one (see What Kinder Morgan Tells Us About MLPs). They chose to pursue their backlog of growth projects rather than maintain payouts.
Corporations Targa Resources (TRGP), Oneok (OKE), and SemGroup (SEMG) similarly acquired their MLPs. This maintained the dividends paid by the parent which also gained a tax shield, but as with Kinder Morgan, their MLP unitholders saw distributions cut in a taxable transaction. An MLP investor base that had been promised stable and tax deferred income got neither. Plains All American (PAA) and Williams Partners (WPZ) both cut payouts as they simplified their structures. When NuStar (NS) CEO Brad Barron explained recently why they were combining their General Partner with their MLP, he cited 54 MLP distribution cuts since 2014 (NS made it 55).
One consequence of reducing payouts has been the alienation of the traditional MLP investor: the older, wealthy, taxable American. The covenant of stable distributions has been broken. Although in many cases it’s been replaced with the promise of future growth, that’s not interesting to an income-seeking investor. Today’s 8.24% yield on the Alerian MLP Index represents an investment opportunity, but it also represents a financing failure for MLPs. Because investors don’t trust the yield, the cost of equity for MLPs is higher than it should be.
MLP managements are speaking out. Brad Barron recently said, “…MLPs with low coverage and high leverage have been effectively shut out of the MLP equity markets, and even MLPs perceived as ‘healthy’ have found it increasingly difficult to issue common equity.” He followed up with, “…the exodus of MLP retail investors, and the nearly frozen equity markets- have called the long-term viability of the MLP model into question.”
A couple of weeks ago Tallgrass (TEGP) CEO David Dehaemers commented to us on why they’d abandoned the MLP model only five years after taking Tallgrass Partners (TEP) public (see A Chat with Tallgrass CEO David Dehaemers). John Chandler, CFO of Williams Companies (WMB) fielded questions on possible plans for their MLP Williams Partners (WPZ). On Friday’s earnings call Transcanada (TRP) said financing assets at their MLP, TC Pipelines (TCP) was no longer viable.
MLPs are converting to corporations because the MLP structure has turned out to be a poor source of growth capital. The Shale Revolution requires financing to build new infrastructure, and income seeking investors aren’t that keen to provide it.
In recent years MLP-dedicated funds have developed to provide MLP-exposure without the K-1 headache to mutual fund and ETF buyers. Such funds labor under a corporate tax liability (see AMLP’s Tax Bondage), incurring an additional cost which can be substantial in a strong market. In 2013-14 when sector returns were very good, taxes and other expenses ate up a third of returns for some funds, and on top of that holders still faced their own investment tax bill.
Moreover, we know from many, regular conversations that few financial advisors using such vehicles appreciate the tax drag their fund choice incurs. Mutual funds and ETFs don’t pay tax, so it’s not an obvious consideration – unless they’re MLP funds. The sharp drop on March 15th following the FERC ruling betrayed the narrowness of the investor base.
However, MLPs are certainly not going to disappear entirely. To MLPs that don’t need external growth capital, such as Enterprise Products (EPD) or Magellan Midstream (MMP), the depressed values of MLPs doesn’t matter much. Their owners can continue to enjoy the tax efficiencies, which include no corporate tax and deferral of income tax on the majority of distributions. But for most companies, the point of a public listing is access to capital. Traditional income seeking investors and tax-burdened MLP-dedicated funds are the two main investor groups – not a very reliable set of buyers on which a CFO might rely.
A shrinking MLP universe won’t hurt Alerian; as Stacey Morris notes, “We’re an indexing firm. We’re not in the business of giving investment advice.” Alerian publishes plenty of indices, and can add more. But holders of tax-burdened, MLP-dedicated funds have an additional risk to consider as MLPs incorporate, and they could use some advice. An analyst at East Daley recently warned that the FERC ruling may cause some firms to drop the MLP structure. Williams Partners (WPZ), Plains All American (PAA), EQT Midstream Partners (EQM), Antero Midstream Partners (AM), Spectra Energy Partners (SEP), TC Pipelines (TCP) and Enbridge Energy Partners (EEP) may all ultimately be rolled up into corporate parents.
In addition, the 12.6% yield on Energy Transfer Partners (ETP) is a powerful inducement to find an altered structure that attracts more investors. Without these, what’s left will represent an even narrower exposure to energy infrastructure than it does today. MLP-dedicated fund investors should be wary (see The Alerian Problem). Fewer names will either lead to more concentrated portfolios of less liquid securities or a highly disruptive shift to a broader index. Restricting your energy infrastructure investments to MLP-dedicated funds might be too narrow. Like the disappearing Cheshire cat in Alice in Wonderland, you may be left to contemplate just a smile.
We are invested in ENB, EQGP, ETE, KMI, NSH, OKE, PAGP, SEMG, TEGP, TRGP, TRP and WMB
FOMO (Fear of Missing Out) hasn’t been much of a problem for energy infrastructure investors over the past year or so. Feelings of WAIL (Why Am I Long?) and (ahem) WTF have been far more common. So the recent rally in the sector has led many investors to enquire why. Earnings only began to be released on Wednesday when Kinder Morgan (KMI) announced a 60% dividend increase and $500MM of stock repurchases since December. Although the dividend hike was expected, the stock nonetheless gained ground. KMI’s 2014 simplification, when they moved from four public entities to one, heralded the conflict between the old and new business model.
Shale Revolution-induced growth opportunities pursued by management collided with the desire of income-seeking investors for steadily growing cashflows (see Will MLP Distribution Cuts Pay Off?). An adverse tax outcome and two distribution cuts followed for original investors in Kinder Morgan Partners. MLP simplification became synonymous with abuse of your core investors, at least until Tallgrass (TEGP and TEP) recently managed to execute one that was well received.
Nonetheless, the persistent high yields on MLPs betray the skepticism of their traditional investor base of older, wealthy Americans. Last year Oneok (OKE) combined with its MLP Oneok Partners, inflicting a KMP-type tax bill on long-time MLP holders. One friend of mine held its predecessor Northern Border Partners from the 1990s, and received an unexpected tax bill on deferred income recapture that was timed to suit OKE, not him. Such investors are not about to commit new money to MLPs. This is the problem facing MLPs but not corporations. MLPs are cheap, but they’ve alienated their core investor base, which is already narrow. This is why investors need to look for broad energy infrastructure exposure including corporations, and not be limited to MLPs (see The American Energy Independence Index). KMI’s $500MM stock buyback would not have happened when they were structured as an MLP.
Substantive developments to explain the rally are few, although Saudi comments favoring $80 oil have helped. Technical analysts have noted that energy infrastructure shows signs of bottoming, something not heard since 2016. Energy stocks are gaining more airtime on CNBC. More tangibly, on Wednesday, the WSJ’s Is the U.S. Shale Boom Hitting a Bottleneck gathered substantial attention by suggesting, “…the U.S. shale boom appears to be choking on its own growth…”
The article included a chart (reproduced here) that is a true object of beauty to any pipeline owner. The problem of sharply growing crude oil production in the Permian is testing the limits of take-away pipeline capacity. Crude oil located in Midland is usually worth less than in Houston, where it’s conveniently near refineries and export facilities. The price difference is typically going to be limited by the cost of pipeline transportation, which is around $2-3 per barrel. Permian output is currently 3.1 Million Barrels per Day (MMB/D), with pipeline take-away capacity of 3.2MMB/D.
The price differential has widened beyond the pipeline tariff because not all the crude wishing to travel to Houston can get in a pipeline. Some is moving by rail (around $8 per barrel) while truckers charge from $10 to as high as $15-20 (truck drivers are in high demand in Texas).
This is a problem for Permian oil producers, since the increased cost of getting their product to market eats into margins. However, it’s a profit opportunity for pipeline owners, since the portion of their capacity that is sold at market rates is now much more profitable. Bottlenecks are good for infrastructure owners. They make money from regional price differentials in excess of the costs of storage and transportation. When Plains All American (PAGP) cut their distribution last year, they blamed it on a collapse in their Supply and Logistics division as regional price differentials were boringly close to transportation costs, minimizing arbitrage opportunities.
Some additional pipeline capacity can be squeezed out through more efficient utilization. Drag reducing agents (millions of tiny polymer string segments) can be mixed with crude which, through the magic of hydrodynamics, reduce turbulence as the liquid travels. But meaningful new capacity isn’t expected until 2H19, which on current trends should maintain the steep Midland-Houston discount and support continued higher pipeline tariffs. Among the beneficiaries of this are PAGP, Energy Transfer Equity (ETE) and Enterprise Products Partners (EPD).
We are invested in EPD, ETE, KMI, PAGP and TEGP
Continuing our series of interviews with senior energy executives, we recently had the opportunity to catch up with David Dehaemers, President and CEO of Tallgrass Energy GP (TEGP). The theme of our discussions was: How has the Shale Revolution changed your business? Behind the miserable recent performance of energy infrastructure securities lies the most fantastic American success story. U.S. oil and gas production have significantly altered global markets, culminating with OPEC’s 2016 about-face on low oil prices (see OPEC Blinks).
OPEC tried to bankrupt the U.S. Shale industry and failed, because the American capitalist system showed its flexibility. Innovation and productivity improvements substantially lowered break-evens for U.S. producers. Since then, a constant source of investor frustration has come from trying to reconcile booming domestic production of hydrocarbons with the languishing stock prices of the businesses that gather, process, transport and store them.
The Shale Revolution has impacted Tallgrass as much as any business. CEO Dehaemers noted that their Pony Express crude oil pipeline that runs from Wyoming to Cushing, OK probably wouldn’t exist without it. Even more striking has been the change to Rockies Express (REX), the natural gas pipeline originally built to supply Rocky Mountain gas to Ohio and beyond. As Marcellus Shale production turned the region from an importer to an exporter of natural gas, REX’s prospects, especially at its eastern sector, dimmed.
So Tallgrass reversed the flow of the pipeline, allowing Pennsylvania gas to supply Chicago and the midwest. In the process they created a “header” system that, by running in both directions across the northern U.S. can link up with north-south pipelines to add further supply routes. We’ve written about this in the past (see Tallgrass Energy is the Right Kind of MLP).
As well as the impact on Pony Express and REX noted above, Dehaemers commented that the Shale Revolution had allowed better use of their existing assets. Like all midstream businesses Tallgrass works closely with their producer customers, seeking to ensure that infrastructure capacity is synchronized with growing oil and gas production. The trend is towards fewer vertical wells as drillers employ multi-pads (“mega-pads”), often consisting of up to 16 wells within 400 yards of one another, each with multiple horizontal wells branching off. This is a significant source of the dramatic productivity improvements that many Exploration and Production (E&P) companies have enjoyed in recent years.
Tallgrass recently announced the combination of their General Partner, TEGP, with their MLP Tallgrass Energy Partners (TEP). Several of their peers have executed “simplifications”, beginning with Kinder Morgan in 2014. Generally they’ve been disappointing, resulting in a distribution cut for MLP holders and sometimes an unexpected tax bill if the combination is determined to be a sale of the assets. A lower stock price has duly followed, and simplification has come to mean loss of value for investors. Unusually, Tallgrass managed to pull off their GP/MLP combination without a distribution cut, and although TEP investors will face a tax bill it won’t be much as the income tax deferral only dates back to the 2013 IPO. Few such simplifications have been well received by the market, but this one was thoughtfully done and investor response was positive.
We were interested to learn why Dehaemers had decided the MLP structure was no longer appropriate, given that only five years earlier they’d floated TEP as a publicly traded MLP. He felt that some businesses had been launched as MLPs without the stable underlying cashflows that the investor base typically seeks. He also felt that K-1s were a bigger impediment than generally thought. We believe a still underappreciated fact is that older, wealthy Americans are the main source of MLP demand. Their distributions have been cut as cashflows have been redirected to reduce imprudent leverage and finance growth projects. The consequent 30% drop in distributions (as seen on Alerian-linked products, see Will MLP Distribution Cuts Pay Off?) renders high yields less compelling. David generally agreed with this assessment, noting that some other firms had unfortunately “gotten over their skis” with more risk than was appropriate. We’d add here that Tallgrass has been a welcome exception, having delivered consistently strong annual distribution growth (32% at TEP and 55% at TEGP since its 2015 IPO).
Although the MLP structure retains its advantageous tax treatment compared with corporate ownership, Dehaemers felt that the sector was unlikely to enjoy a resurgence as a substantial source of capital anytime soon. Incentive Distribution Rights (IDRs), whereby the GP earns preferential economics for running the MLP, have been widely criticized. We’ve long thought that this issue is overplayed, as investors in hedge funds and private equity routinely accept preferential economics for their fund managers. However, David noted that social media pays far less attention to these private vehicles than to publicly traded securities, and he felt that growing IDR opposition was a factor.
We were curious to know whether Dehaemers thought Tallgrass Energy (TGE), the entity resulting from the combination of TGP and TEP, would be included in the Alerian Index. Given the shrinking number of MLP names, the index is becoming less representative of energy infrastructure (see The Alerian Problem). TGE is unique in that it’s a single partnership electing to be taxed as a corporation with no publicly traded affiliate, so it’s unclear whether Alerian’s current rules would include it. Dehaemers had not given this much thought, perhaps because the point of the combination is to access a broader set of investors than those interested in MLPs.
Tallgrass is a company that we expect to benefit from American Energy Independence, and it’s included in our similarly named index.
Lastly, we noted the high 9.6% yield on TEP (TGE after the combination), and asked how they think about the division of cash between investor returns and paying for new projects. Dehaemers felt the 1.2X distribution coverage should encourage buyers to drive the yield down, and combined with mid-to-high single digit % growth TEP is an attractive investment. We agree, and will continue to follow Tallgrass’s progress with interest.
We are invested in TEGP
On Tuesday, May 8th we’ll be ringing the 4pm closing bell at NYSE in recognition of our recently launched
Last week’s blog, The Alerian Problem, drew a bigger than average response. We reposted it on Seeking Alpha where you can see all the comments from readers. More interestingly, it led to a useful dialogue with sell-side analysts and investors.
The shift from MLP to corporate ownership of energy infrastructure is becoming widely acknowledged. Since the FERC announcement in early March disallowing MLPs from including imputed tax expense in setting certain tariffs, corporates have handily outperformed MLPs. Although the near-term impact is likely minimal, the ruling will eventually impact some liquids pipelines as well as natural gas. It does seem likely to limit dropdowns of eligible assets from corporate owners to their MLP as well as hasten conversions to corporate ownership.
One analyst we’ve spoken to wrote of, “…strong evidence of the potential catalytic response available to partnerships that could convert…” from MLP to corporate ownership, citing the jump in Viper Energy Partners (VNOM) and Tallgrass (TEGP/TEP) since each abandoned the MLP structure.
The Alerian Problem, which specifically asks what MLP-dedicated mutual funds and ETFs will do as their index shrinks, has no easy answers. Weak relative MLP performance will not help flows which have in any case been flat for such funds, and redemptions will continue to weigh on prices, encouraging additional MLP->Corporate conversions.
MLP funds can continue to hold names that have converted to corporate status, and in conversations with investors we understand some have indicated they may do this. However, since such funds are already burdened with paying corporate taxes (see AMLP’s Tax Bondage), holding tax-paying corporate equities in a tax-paying corporate fund structure is going to strike many investors as absurd.
Therefore, such funds will be left with a choice between picking amongst a shrinking pool of names, or the nuclear option of switching indices since they’d then dump their MLPs. It’s probably best not to be the last tax-burdened MLP fund to make such a switch, nor the last fund investor to redeem from such a prospect.
One investor we spoke to last week found this sufficient reason to exit his remaining tax-burdened MLP funds in favor of a more efficient, RIC-compliant structure. In a sign other investors have already begun doing the same, the Alerian MLP Fund (AMLP) has seen its AUM drop from $10.3BN at year-end to $8.6BN, a 17% drop and substantially worse than its YTD performance of -11.6%.
On a positive note, the recent ratcheting up of trade tensions has given investors a reason to own energy stocks. Tariffs on crude oil or Liquified Natural Gas are hard to imagine and probably impractical. Since Gary Cohn’s March 7th resignation signaling a more confrontational approach was ascendant on such issues, the S&P Energy sector has outperformed the broader market by 5%.
We are short AMLP
In 2005, when I was providing seed capital to emerging hedge funds at JPMorgan, we met with Alerian’s founder Gabriel Hammond. “Gabe” knew a great deal about Master Limited Partnerships, and he was convinced that the sector needed an index in order to grow. He was right, and Alerian’s index became the most widely used benchmark for MLPs. We seeded Alerian Capital Management’s offshore hedge fund.
Back then, MLPs were synonymous with energy infrastructure. To invest in one was to invest in the other. But as regular readers know, much has changed since then. MLPs are now a shrinking subset of energy infrastructure. The Shale Revolution created the need for growth capital to build new pipelines, because crude oil hadn’t previously been sourced in North Dakota, nor natural gas in Pennsylvania. The MLP’s promise to pay investors 90% of Distributable Cash Flow (DCF) came into conflict with their desire to invest in new projects. The older, wealthy Americans who owned MLPs were there for the regular income. Foregoing some of today’s distributions in exchange for the promise of higher future returns wasn’t appealing, and MLPs turned out to be a poor source of growth capital. MLPs began “simplifying”, in many cases becoming regular corporations where payout ratios are far less than 90% and investors are global. In short, the older, wealthy American turned out to be the wrong type of investor for midstream energy infrastructure’s response to the Shale Revolution. MLPs were no longer equivalent to energy infrastructure.
We’ve watched and participated in this evolution as investors. It’s an ongoing source of considerable frustration to many that the energy sector has performed so poorly when the fundamentals appear so promising. The price of oil peaked along with sentiment in 2014, since when the S&P Energy ETF (XLE) has dropped 18% while the broader S&P500 is up 52%. Volumes continue to grow, with crude oil, natural gas and its related liquids (such as ethane and propane) all reaching new records this year.
The higher volumes will ultimately drive higher profits for the midstream infrastructure businesses that gather, process, transport and store them, although the alignment of production and stock returns is becoming an interminable wait. In the meantime, the vast majority of funds that specialize in energy infrastructure are dedicated MLP funds. They face a tax drag (see AMLP’s Tax Bondage), and a shrinking pool of names (see The Alerian Problem).
Corporations, not MLPs, control U.S. energy infrastructure. And yet, some of the biggest operators such Kinder Morgan (KMI, market cap $34BN), Oneok Inc (OKE, market cap $24BN), Williams Companies (WMB, market cap $21BN) or Cheniere Inc (LNG, market cap $13BN) don’t appear in the MLP-dedicated funds that, as a result, no longer represent a broad investment in energy infrastructure.
The American Energy Independence Index (AEITR) constituents have a market cap of more than twice that of the Alerian Index. The AEITR also includes General Partners (GPs), whose control of many MLPs provides them with preferential rights as well as being the investment of choice for most management teams (see MLPs and Hedge Funds Are More Alike Than You Think). The AEITR includes some Canadian names, since North America’s pipeline network crosses the border in numerous places and some significant elements of U.S. infrastructure are connected to their northern neighbor’s network.
The result is a far more complete representation of midstream infrastructure. The American Energy Independence Index represents the future, which increasingly is corporate ownership of assets, versus the outdated model limited to MLP ownership. For investors seeking to follow the Shale Revolution’s drive towards American Energy Independence, we believe it offers a superior way to participate.
We launched the index in November, and its associated ETF in December. We think because AEITR is more diversified, it has demonstrated 11% smaller average daily moves than the Alerian Index. Given Alerian’s shrinking pool of eligible MLP names and more concentrated sector exposure, we expect the American Energy Independence Index to continue exhibiting lower volatility.
What do you do if your fund’s index is shrinking? This is the dilemma that many retail investors in MLP-dedicated mutual funds and ETFs will be confronting in the months ahead.
The trend for MLPs to simplify by combining with their corporate General Partner (GP) is well established. The recent Federal Energy Regulatory Commission (FERC) ruling (see FERC Ruling Pushes Pipelines Out of MLPs) prompted us and other observers to conclude that this trend is likely to continue, if not accelerate (see Are MLP Going Away?). Last week Tallgrass Energy Partners (TEP) combined with its GP Tallgrass Energy GP (TEGP), the first such announcement since the FERC ruling on taxes and one of the few simplifications to result in a bounce in the stock price. TEP will drop out of the Alerian Index, reducing the number of constituents to 41. At the end of 2015 it stood at 50.
On Monday, oil driller Legacy Reserves LP (LGCY) announced they were converting from an MLP to a corporation, causing their stock to jump 11%. CEO Paul Horne clearly will not miss running an MLP. In the press release, he noted that, “…we look forward to stepping out from the dark cloud we have been under as an upstream MLP.” On Friday, Viper Energy Partners LP (VNOM) jumped 10% after electing to be taxed as a corporation. Simply by agreeing to be a taxpayer, thereby issuing 1099s instead of K-1s, they became more valuable. Their presentation noted, “VNOM will be uniquely positioned as a first-mover and leading public minerals yield vehicle without the limitations of an MLP.” These moves reflect the disdain investors have developed for the MLP structure, and the bigger ones contemplating their own conversion will have taken note.
The reduced corporate tax rate makes MLPs relatively less attractive. FERC’s elimination of imputed tax expense, although inconsequential in the near term, will affect cashflows for some interstate natural gas pipelines and, in a couple of years some liquids pipelines too. Moreover, MLP yields remain stubbornly high. They are attractively valued, but as such they represent an expensive source of equity capital for issuers. The older, wealthy American who is the typical MLP investor wants steady income. The shifting of cashflows to fund new infrastructure projects demanded by the Shale Revolution has alienated him (see Will MLP Distributions Pay Off?). All these factors are reducing the value of putting eligible assets in an MLP.
As a result, MLPs are less than half of the midstream energy infrastructure sector, and each MLP simplification further reduces their number. This need not matter much for a holder of individual MLPs. As your MLPs convert to corporations, your portfolio’s composition shifts as well. TEP investors will still own the same assets via Tallgrass Energy, LP (TGE), a corporation for tax purposes.
But if you’re invested in an MLP-dedicated fund, you and your fund manager face a problem. A shrinking Alerian MLP Index (AMZ) creates a dilemma for funds that are benchmarked to it. If they do nothing, the index (and therefore, the fund) will become steadily less representative of the sector, with fewer names and a smaller median market cap. Today, the median market cap of AMZ’s constituents is only $1.8BN, compared with $15BN for the broader American Energy Independence Index (AEITR). Not coincidentally, since the FERC announcement broader, corporate exposure to infrastructure has outperformed the MLP-dedicated Alerian index.
To put this in perspective, the Alerian MLP ETF (AMLP), various tax-impaired mutual funds offered by Oppenheimer Steelpath, Goldman Sachs, Center Coast and Cushing, along with the JPMorgan Alerian MLP Index ETN hold a combined $24BN in MLPs linked to AMZ. This is 14% of AMZ’s float-adjusted market cap. If these funds do nothing, tracking their index will shift them into more concentrated portfolios, or smaller names, or both.
Rather than fight against this tide, it might make sense for them to consider switching to a more representative index that better reflects energy infrastructure. However, like watching elephants dance, it’s unlikely to be elegant. If AMLP announced that it was substituting a different, broader index, that would immediately depress the prices of those MLPs that it would need to sell, hurting performance immediately. Actively managed mutual funds could implement portfolio shifts to a broader index over weeks or months, and although this might lessen the immediate market impact, it would introduce tracking error against both old and new benchmarks. It would likely be disruptive to their performance.
If all these funds sold 75% of their MLPs they could even claim to be RIC-compliant and no longer subject to the drag of corporate taxes. Unfortunately, that would require selling $BNs of MLPs, and the reason MLPs are converting to corporations is because MLP prices are depressed.
MLP-dedicated funds face an unenviable business decision, and they’re clearly best served by the status quo. Their best outcome is to delay changing their benchmark indefinitely, and hope to convince their retail investors that MLP-only funds remain a viable proposition. The risk for current and future holders is that the shrinking Alerian Index eventually forces them to change, which could be tumultuous. It might be one reason why net inflows to MLP-dedicated funds are flat since last Summer. In addition to the headwinds of corporate taxes (see AMLP’s Tax Bondage), you can add index uncertainty. It’s The Alerian Problem.
We are short AMLP
MLP investors have certainly seen their conviction tested of late. Poor stock performance was recently compounded by the Federal Energy Regulatory Commission’s (FERC) ruling on cost of service contracts earlier this month. Although MLPs don’t pay tax, interstate natural gas pipeline tariffs based on cost-of-service have historically included an allowance for taxes paid by their investors. Following a court challenge by United Airlines, FERC has now disallowed this practice.
Since last year’s tax reform, MLPs have already included lower imputed tax expense in their guidance. After the FERC ruling, most firms reaffirmed prior guidance, since the immediate impact of the change is quite narrow. However, the loss of the tax allowance will impact gradually over the next few years. Along with the drop in the corporate tax rate from 35% to 21%, it further reduces the relative advantage of MLPs compared with corporate ownership of energy infrastructure assets.
The trend favoring corporate ownership is well established. As we’ve written before, MLP investors (generally, older wealthy Americans) want their distributions and don’t much care for the distribution cuts that have been necessary to finance growth projects (see Will MLP Distribution Cuts Pay Off?). These investors are income-seeking, not total return oriented. It’s why MLP yields remain stubbornly high, and is behind the many “simplification” transactions that move assets to corporate ownership and cut payouts.
FERC’s ruling probably helps that ongoing trend towards corporations (see FERC Ruling Pushes Pipelines Out of MLPs). MLPs are complex, with a limited investor base, and are losing some of their comparative advantage over corporations because of changes to the tax code. They already represent less than half of energy infrastructure. The tax ruling by FERC doesn’t affect corporate owners, since their tax expense is real, not imputed as was the case with MLPs.
If you’re a direct holder of MLPs, as long as the assets continue to perform there’s not much reason to do anything. You may ultimately wind up owning shares in a corporation if the MLP converts, and it might even be acquired. The tax consequence of waiting is likely no worse than selling your MLP today.
However, investors in many MLP-dedicated funds that are not RIC-compliant face a real dilemma. As the number of MLPs contracts, these funds will struggle to find enough names to own. The Alerian Index has been shrinking for some time, both in market cap and constituents. Investors in the wrong kind of fund face a corporate tax haircut as well as a declining opportunity set.
There’s some recent evidence since the FERC ruling that investors are starting to favor corporate infrastructure names over MLPs. So far in March, the American Energy Independence Index, which consists of broad energy infrastructure exposure with only 20% in MLPs, has handily outperformed the more narrow, MLP-dedicated Alerian Index by 2.7%. This outperformance has come since the FERC ruling. Anecdotally, we know some investors are switching from tax-paying funds into pass-through, RIC-compliant ones because that’s all we offer and we are seeing the inflows.
Since last Summer, we calculate that tax-impaired funds have seen net outflows, as investors have become more aware of the performance drag (see AMLP’s Tax Bondage) and the shrinking opportunity set. Meanwhile, properly structured RIC-compliant funds with no tax drag picked up almost $900MM over this time. It’s reflected in the shrinking float-adjusted market capitalization of the constituents of the Alerian Index, which is less than half of its 2014 peak, significantly lower than performance alone would imply.
The number of Alerian constituents has also shrunk noticeably since 2014. Just six names make up half its market cap, and seven have a market cap of below $1BN. Williams Companies (WMB) could well conclude that the FERC ruling means they’re better off owning their sprawling interstate natural gas pipeline network, Transco, at the corporate level, thereby eliminating MLP Williams Partners (WPZ). Enbridge (ENB) could easily absorb the remaining public float of Spectra Energy Partners (SEP) and Enbridge Energy Partners (EEP) to offset FERC’s impact on their cost-of-service tariffs. Plains GP Holdings (PAGP) will eventually covet the tax shield that would come from absorbing the remaining units of its MLP, Plains All American (PAA).
Combined, losing these four would reduce the market cap of the Alerian index by $24BN, about 17%. By comparison, the two new names added in 1Q18 (Hi-Crush Partners and CVR Refining) have a combined market cap of only $1.5BN. The Alerian MLP Index is not what it used to be.
The American Energy Independence Index has a float-adjusted market cap of $315BN, more than twice Alerian, reflecting its broader approach. Investors are starting to take note.
We are invested in ENB, PAGP and WMB
The fragile mental state of MLP investors left them ill-prepared for Thursday’s ruling by the Federal Energy Regulatory Commission (FERC). By modifying how MLPs calculate certain tariffs, it sent the sector on another wild afternoon ride. It’s a complex issue – pipelines owned by MLPs that cross state lines and rely on FERC-regulated tariffs are most vulnerable. MLPs can no longer set tariffs by including taxes paid by their investors in calculating full cost of service (since MLPs are largely non-taxpayers themselves).
However, it’s possible to find many exceptions – large swathes of the U.S. pipeline network operate intrastate and are therefore generally not governed by FERC. Many contracts are negotiated or have market-based rates, and there are plenty of cases where customers have few attractive alternatives to their existing infrastructure provider. Pipelines owned by corporations rather than MLPs should be relatively unaffected, while non-pipeline energy infrastructure assets are also immune, including gathering, processing, terminals, fractionation, storage, and Liquified Natural Gas facilities.
But the ruling did provide another example of the complexity in the MLP structure. Investors have already had to contend with management teams redirecting cash flows from payouts to new projects (see Will MLP Distribution Cuts Pay Off?). MLP Limited Partners still tolerate their junior position relative to a General Partner (GP) that retains control, although the GP’s payments received via Incentive Distribution Rights (IDRs) are increasingly being phased out. K-1s have always been unpopular, and compounding 2017’s disappointing performance, users of the PWC website for electronic download are confronting additional authentication requirements that add to the burden of tax preparation.
Meanwhile, the FERC ruling exposed one more element of complexity. Calculating cost of service by including investors’ tax expense is another quirky feature of the MLP structure. Such tax rates are in any case unknowable by the MLP. The market’s superficial understanding of the issue was reflected in the sector’s initial 10% drop on Thursday before recovering approximately half, and by Friday prices were barely changed from prior to the ruling. In any event, few contracts nowadays are negotiated in such a way that FERC’s ruling affects them, compared with older, legacy contracts. Figuring in owners’ taxes turns out to be another anachronistic feature of MLPs.
Investors continue to show their disdain for the sector. Management teams long ago broke the implicit contract of stable payouts. The 30% cut in distributions since 2014 is reflected in the 40% drop in the Alerian Index. CEOs promise that much of this redirected cash will result in faster growth, and 15% annual Free Cash Flow (FCF) growth looks plausible to us. But the business model of attractive yields with little need to reinvest in the business has shifted in response to the opportunities created by the Shale Revolution. The older, wealthy Americans who were long the main MLP investor wanted their distributions, and this pursuit of growth projects has alienated them by disrupting their income. Consequently, the market is waiting to see if new projects will generate promised higher returns.
MLPs now represent less than half of U.S. Energy infrastructure, because the MLP has turned out to be a poor source of growth capital. MLPs are far from irrelevant, but they are a shrinking subset. The FERC ruling was another reason to make both investors and MLPs themselves question whether the structure is still worth the trouble. Furthermore, to be an investor in a dedicated MLP fund is to miss most of the sector as well as incur a substantial corporate tax drag (see AMLP’s Tax Bondage). Broad exposure to energy infrastructure through a RIC compliant fund that caps MLP investments at less than 25% looks increasingly preferable.
However, there’s another class of investor that sees much to like in energy infrastructure, and that’s private equity. Although there’s limited public data available on transaction prices, these long term investors are steadily investing in long term energy assets. Blackstone acquired MLP asset manager Harvest Fund Advisors last August, in a clear bet on a resurgent asset class, having just paid $1.5BN for 32% of Energy Transfer’s Rover pipeline. Tortoise, another large MLP asset manager, sold out to a group of private-equity firms led by Lovell Minnick Partners. Other private buyers include 4 AM Midstream (acquired midstream assets from White Star Petroleum), Meritage Midstream (acquired Powder River basin subsidiary of Devon Energy), and Stakeholder Midstream (Permian gathering system).
Earnings calls often include grumbling that private equity, with its locked up capital, is outcompeting public MLPs for projects. Energy Transfer’s Kelcy Warren complained, “We lose out on projects routinely these days to private equity, not really to our peer group… there’s just a lot of private equity that hires management teams and they’re in for the short term. But it doesn’t matter, they’re winning and we’re not.”
FERC’s Thursday ruling on tariff calculations added another source of volatility to a sector not short of it. Later in the day, Enterprise Products Partners (EPD) CEO Jim Teague stated, “We do not expect the revisions to the FERC’s policy on the recovery of income taxes to materially impact our earnings and cash flow,” Other large firms soon followed, including Kinder Morgan. So the market’s initial response was disproportionate, but its vulnerability to a relatively obscure issue simply highlighted unnecessary complexity.
Energy infrastructure assets are doing fine, but the MLP entities that own them are taking a succession of body blows. The corporate ownership of energy infrastructure assets, with its access to worldwide equity investors and simpler tax reporting, is looking ever more attractive. On the week, the narrowly MLP-focused Alerian MLP Index was -2.9% whereas the broader American Energy Independence Index was -1.0%, as investors favored corporate ownership over MLPs following FERC’s ruling.
Investors in MLP ETFs such as AMLP, and similar MLP-dedicated mutual funds, already face a corporate tax drag (see again AMLP’s Tax Bondage). They are likely to see MLPs continue to lose favor as a financing vehicle, with a consequent diminution of names to hold. Investors who desire to profit from the Shale Revolution and the path to American Energy Independence should switch out of MLP-focused, tax-impaired MLP funds and into broader energy infrastructure exposure relying on simple corporate ownership of assets with no tax drag.
We are invested in Energy Transfer Equity (ETE), EPD and KMI