Investors Look Warily at the Persian Gulf

The Shale Revolution has certainly provided America with more geopolitical freedom. The 1973 Arab oil embargo punished the U.S. for supporting Israel, as it fought Egypt and Syria. Shortages of gasoline visibly demonstrated the limits to U.S. actions. As a result, every president since Nixon has called for energy independence.

Swaggering energy dominance is the new goal, since independence has, by some measures, already been achieved. But reduced dependence on imports doesn’t bring immunity from price spikes, given that oil is a global commodity easily moved to the most eager buyer.

A benefit of investing in midstream energy infrastructure that we rarely hype is its domesticity. There are pipelines all over the world, but we stick to North America where property rights and rule of law are secure. Weakness in, say, the Turkish lira is of no concern.

Energy markets today are sanguine, in that there is little risk of disruption priced in. Meanwhile, global crude oil demand is growing at around 1.5 Million Barrels per Day (MMB/D). Saudi Aramco’s recent bond offering disclosed production capacity that’s more limited than many had thought.

Venezuela’s output continues to collapse, with U.S. sanctions kicking a chronically mis-managed economy already on its knees. Libya is on the verge of civil war, placing more output at risk. And now the waivers on Iranian exports are about to be cancelled, with the U.S. stated goal of reducing their oil exports to zero.

The 1941 U.S. embargo on Japanese imports of oil and gasoline products led within six months to Pearl Harbor. Today’s Iranian sanctions are similarly intended to heap more pressure on the regime. U.S. warships patrol the Strait of Hormuz, assuring the flow of oil from Iran’s neighbors. Conflict is not inevitable and is hardly a viable proposition for Iran’s leaders. Economic pressure may yet induce Iranian change in policy, or even regime. That’s clearly our goal. But a miscalculation, or the conclusion that no good options remain, are possible.

Global Chokepoints for Crude Oil

In The Absent Superpower, Peter Zeihan’s book on the shifting gepolitical balance caused by U.S. shale, he notes, “Iran has a phalanx of varied missile systems that could reach any point within the strait itself, with many of them capable of reaching the Saudi shoreline even across the wider points of the Persian Gulf.”

Militarily there’s no doubt about the winner, but oil supplies could still be disrupted. A third of global seaborne crude passes through the Strait of Hormuz. In addition, Qatari exports of Liquified Natural Gas (LNG) account for a third of global LNG trade, with Kuwait importing LNG that travels north through the Strait.

Strait of Hormuz

Brent crude exhibits modest backwardation, of around $4 per barrel between June ’19 and June ’20 futures. Conflict with Iran would surely provoke a much bigger jump.

Energy has sunk to around 5% of the S&P500. It’s one of the few sectors (along with Defense) likely to perform well if U.S. military action occurs. Energy stocks, like crude oil, reflect little price premium for geopolitical uncertainty. Through last year pipeline stocks were sufficiently out of favor that their correlation with the S&P500 was sometimes negative. That’s just the relationship a hedge needs with its target portfolio.

Investors who are concerned about increasing geopolitical risks should overweight midstream energy infrastructure. It’s cheap, immune to war damage and provides good protection against Middle East conflict.

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).

AMLP’s Shrinking Investor Base

The Alerian MLP ETF (AMLP) remains the largest ETF in the sector, in spite of its ruinous tax drag (see MLP Funds Made for Uncle Sam) and long term returns that are less than half of its index. It’s been a commercial success for its promoters but unfortunately, a disastrous investment for many holders.

However, there are signs that AMLP’s fan base is slipping. Its share count’s steady growth abruptly stopped last summer. Since then, shares outstanding are down over 8%. Half of that drop has come this year.

AMLP Share Count

Midstream energy infrastructure has been a frustrating sector to be sure, and to some degree AMLP flows reflect broader investor sentiment. Through 2014 assets grew, and even during the 2014-16 energy collapse AMLP’s share count increased.

But since last summer, there’s increasing evidence of lost market share. Figures from JPMorgan show AMLP experienced 2H18 outflows of $942MM, a disproportionate share of the sector’s $2.9BN outflows during that period.

Market direction doesn’t seem to make much difference. Last year’s outflows coincided with sector weakness, but outflows have continued this year even though midstream energy infrastructure has been a leading market performer. AMLP’s 2019 outflows have roughly cancelled out inflows to other funds.

Back in 2010 when AMLP was launched, there was clearly investor demand for MLP exposure that avoided K-1s. The corporate tax drag meant AMLP, an index fund, could never come close to matching its index. Buyers overlooked or were unaware of this weakness.

Much has changed over the years. MLPs used to be synonymous with pipelines, but the limited investor base has led many large companies to convert to corporations. Today, North American midstream energy infrastructure is two thirds corporations by market cap (see Pipelines’ New Look).

The MLP structure remains tax-efficient, but its income-seeking investor base has proven to be a fickle source of equity capital. So those MLPs that remain, such as Enterprise Products Partners (EPD), do so because they don’t need to issue equity. There were no MLP IPOs in 2018. Blackstone recently announced plans to convert from a partnership to a corporation, concluding that the K-1s were not worth the trouble.

The shrinking pool of MLPs reflects this change (see Are MLPs Going Away?). AMLP’s 100% MLP exposure omits many of the biggest pipeline corporations.

AMLP also holds an ignominious position on the Top Ten “Money Burned” ETFs posted on Twitter recently. The sector’s poor performance has a lot to do with this, but the corporate tax drag on top of poor results was enough to gain AMLP entry to the list.

The steady erosion of AMLP’s investor base suggests that investors are starting to acknowledge the ruinous tax drag and the switch away from MLPs to corporations.

Since AMLP holders are deciding to exit, it suggests that MLP prices will continue to experience downward pressure relative to corporations, a trend that has been well established this year. The sector is cheap, but broad energy infrastructure exposure that includes corporations will continue to deliver better results than a narrow, MLP-only approach. AMLP owners should sell, probably taking a tax loss, and move into a more diversified product.

Regular readers will be familiar with our blog posts on the topic, and so now are many investors.

 

We are invested in EPD and short AMLP.

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

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

Chevron Writes Shale’s Next Chapter

In the 1990s U.S. bankers were consolidating. My own career spans several bank mergers. Manufacturers Hanover merged with Chemical Bank in 1992, followed by Chase Manhattan in 1996 and JPMorgan in 2000. Other smaller deals occurred along the way, such as Hambrecht & Quist in 1999, and  Robert Fleming in 2000.

I remember then-CEO of Chemical Bank, Bill Harrison, discussing the inevitable consolidation of the banking industry, and how he had a team that was constantly evaluating the synergies of potential combinations. Relative pricing was an important consideration. Weakness in one bank’s stock could attract others who had already assessed a potential fit. Harrison had a mixed record at mergers until the combination with JPMorgan led to Jamie Dimon eventually running the company. Bill’s final deal left investors in good hands.

Chevron’s (CVX) acquisition of Anadarko (APC) last week reminded me of this. The relative pricing chart that CVX CEO Mike Wirth used in Friday’s call provided a useful insight into how they approached the deal.

Chevron Anadarko Acquisition Relative Pricing

Over the past year, stock prices for the integrated oil companies (IOCs) have outperformed the independent U.S. shale drillers. In terms of CVX’s currency (its stock), APC became cheaper. In effect, the market was pushing for this deal, by steadily improving its attractiveness to CVX. Investors want the world’s biggest companies managing shale oil and gas output.

It wasn’t always this way. In the early days of the Shale Revolution, independent companies like Pioneer Resources (PXD), EOG and others led the way. They had a willingness to experiment with different approaches while the industry sought the most effective techniques to unlock this new resource. Observers felt at the time that IOCs were poorly suited to the type of constant disruptive innovation at which smaller companies can excel.

Recognizing the unconventional thinking required to exploit this unconventional resource, huge companies like Royal Dutch Shell (RDS) created new divisions with considerable autonomy to innovate. It echoed the “skunkworks” popularized by Clayton Christensen in The Innovators Dilemma. His premise was that big companies were too often so invested in their existing products and processes that they were unable to see the threat posed by more nimble innovators. And in the early years of the Shale Revolution, IOCs were generally absent because unconventional plays didn’t fit their conventional thinking.

Frequent failures with their associated learning curve were protected from the centrally-imposed financial discipline that usually prevails. RDS enjoyed sufficient success with this approach that they applied some of the lessons across the company.

The CVX/APC deal highlights how things have changed. IOCs are no longer focused on trying to act like a small company practicing rapid innovation. Instead, they’re applying the scale and efficiencies of a big company to drilling techniques that are now well established. It’s the next stage in the Shale Revolution.

Equity markets accelerated this development, by assigning higher valuations to larger companies versus independents. CVX exploited this in their APC acquisition. It’s likely to spur consideration of other match-ups. Pipeline customers will be increasingly well-capitalized with properly funded, long term production plans. This should only be good news for investors in 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).

Shale Cycles Faster, Boosting Returns

Chevron (CVX) CEO Mike Wirth must have used the term “short-cycle” at least half a dozen times on Friday’s conference call discussing their $33BN acquisition of Anadarko (APC). It’s a feature of the Shale Revolution that’s still unappreciated by investors, even while it’s highly valued by upstream companies. A faster capital cycle boosts returns.

The U.S. Shale Revolution has upended global energy markets, and not only because of cheap, new supply. which is already turning America in to the world’s biggest exporter of hydrocarbons. A decade ago Cheniere (LNG) was building facilities to import natural gas, and energy independence was a pipedream.

Conventional oil and gas projects used to require many $BNs in upfront capital, with a payback over a decade or more. Global GDP growth, production costs and future demand all have to be considered before a final investment decision is made. Climate change and public policy response have added to long term uncertainty for an already cyclical business.

The power of shale extraction is that capital spend is spread out and cash returns come sooner. It costs less than $10MM to drill a well, and in America we drill thousands every year. The high initial production and sharp decline rates return capital invested far more quickly. Output can be hedged because the 2-3 year liquidity of futures aligns with the cashflow cycle of shale far better than with conventional projects. If oil falls, drilling slows. It’s just less risky, which is why investment dollars continue to flow into North America.

CVX isn’t alone in recognizing this. ConocoPhillips (COP) places U.S. unconventional, or tight (as shale is often called) in the upper right of a chart with the best combination of capital flexibility and returns.

Shales Capital Flexibility

This chart from IHS Markit links high capital flexibility with fast initial production.

Tight Oil is Short Cycle

We have often commented on this aspect of growing domestic oil and gas output. See our short video America’s Energy Renaissance: The Short Cycle Advantage of Shale and a piece in Forbes The Short Cycle Advantage Of Shale.

Conventional projects are becoming much smaller. North America, which offers substantial short cycle opportunities, continues to draw investment. The result is that America is gaining share in the world’s energy markets. This is likely to remain the case in almost any scenario, because of shale’s lower risk profile.  Wirth went so far as to highlight that not only is shale among some of the highest return projects in their portfolio, but it’s also among the lowest risk both below and above the ground.

A slide from Enterprise Products Partners’ recent investor day highlights strong growth in Asia over the next couple of decades.

Asia is Driving Hydrocarbon Demand

For pipeline owners, this is enormously positive. North American upstream companies are our customers. The Shale Revolution has plenty of critics who argue that Wall Street continues to provide capital, illogically, to unprofitable activities. And yet well informed investors such as CVX are concluding it’s a very attractive place to be. Last year ExxonMobil (XOM) announced plans to invest $50BN in North America over the next five years. CVX was already planning 900 thousand barrels a day of oil production by 2023 in the Permian before the APC acquisition. XOM expects to produce a million barrels per day there. These companies bring scale and stability, which makes them the most attractive customers possible for midstream energy infrastructure.

This was also positive for Western Midstream Partners (WES), since their business with APC is now likely to grow substantially. In response to a question about its new MLP, Wirth pointed to the Waha basis spread, which is negative, meaning producers are paying to get rid of their natural gas. He noted the importance of offtake and high quality midstream infrastructure, and clarified that WES was a strategic asset for them.

CVX is taking advantage of relative weakness in APC’s stock price compared with their own. Nine months ago they would have had to offer almost twice as big a premium. There were also reports that Occidental Petroleum (OXY) had offered APC $5 per share more, but that CVX’s offer was preferred because it’s regarded as a better partner.

Chevron Anadarko Acquisition Relative Pricing

The bottom line is that the CVX/APC deal is great news for midstream energy infrastructure. CVX’s lower cost of capital and merger synergies can only lead to higher oil and gas production than would otherwise have been the case. Pipeline stocks are poised for a significant rally. Over four years of weakness have led to distributable cash flow yields above 10% that are growing 10-15%. Dividends are rising for the first time since 2014. The sector remains over 30% below its all-time high, even while the S&P500 flirts with a new record. CVX provided further affirmation of the enduring value in U.S. unconventional production.

We are invested in EPD and WES.

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).

Enlink CEO Talks Strategy

Sharply higher commodity prices shouldn’t be a major source of concern for pipeline investors. But that was the answer Enlink (ENLC) President and CEO Michael Garberding gave to a question we’re often asked – what could go wrong. His reason was that it would induce midstream infrastructure to add excess capacity. “Our industry has shown it knows how to overbuild” was heard more than once during a recent investor dinner hosted by MUFG Securities. This set the tone for the evening’s conversation. Adrianne Griffin, Director of Investor Relations and whom we interviewed last year (see Discussing the Shale Revolution with Enlink Midstream), smoothly guided Mike to expand on issues of most interest.

Enlink Midstream

Promoting the CFO to CEO doesn’t always guarantee a culture of financial discipline. For example, Kinder Morgan’s distribution cuts and taxing simplification, all to support their growth plans, took place while President Kimberly Dang was CFO. But we felt Mike Garberding had a good grasp of the company’s financial profile when he held that role, and hope to see it woven more fully into Enlink’s culture.

Any discussion with energy sector management is likely to cover the spread between cost of capital and project returns, prudent leverage and improved returns to shareholders. This dinner was no exception. ENLC expects their $1.2-1.5BN in growth capex to generate $250MM in annual EBITDA when completed, an attractive 5-6X build multiple if they achieve it.

Last year Devon Energy (DVN) sold their Enlink interest to Global Infrastructure Partners (GIP), and then Enlink consolidated their GP and MLP into a single LLC entity that is taxed as a corporation. Given ENLC’s current valuation and attractive projects, you might think GIP would want to buy the whole company, with the substantial pool of private equity dedicated to infrastructure investments. GIP’s role remains something of a mystery. Garberding noted that they were “very aligned with GIP” and that “they give us huge strategic advantages”. But specifics are few, and one investor asked when the benefits of GIP’s strategic role would become clearer. More detail would be welcome. Mike noted that there had been little opportunity to provide more clarity since last summer’s deal, given the just completed simplification. Hopefully, we’ll learn more in the future.

Another investor asked whether ENLC would sell their Barnett shale assets to a potential acquirer of DVN’s acreage, if the buyer was seeking more vertical integration. This was thought unlikely (though “every asset has a sale price”), and Garberding noted that if the new owner adds one more rig that would double the rig count on a play that requires very little annual capital, albeit with output currently declining 4-5% annually.

Upstream customers seem to be showing more stability – ENLC expects rig counts to be maintained across a wider range of oil and gas prices than in the past, which probably speaks to improving balance sheets across the energy sector. Drillers are showing, “a better capability to live within their cashflows.” It’s why he believes gathering and processing businesses are less risky than sometimes believed.

Vertical integration increases the number of opportunities to earn a fee from a molecule, and ENLC regards that as a critical means of competing with bigger firms such as Plains All American (PAGP) and Enterprise Products Partners (EPD), both of whom offer integrated solutions. Providing shippers with optionality and affording customers a choice of where to direct their output to maximize profits remains a key focus.

Connecting with other networks adds choices, and ENLC does this extensively with Oneok’s (OKE), for whom they are a top five customer.

CFO Eric Batchelder was jokingly referred to as the “C-F-No” as if to emphasize C-suite financial discipline. There was an interesting exchange on the balance between returning cash to shareholders via buyback versus distribution growth. The 9% yield on ENLC’s equity suggests that too few investors are attracted to the stock, and therefore a planned 5% increase in payout is unlikely to entice them. Some investors, including ourselves, would prefer that excess cash be returned through buybacks. Since buybacks reduce the sharecount, there’s the added benefit of raising coverage on the dividend

However, Batchelder noted that opinions varied and a significant number of long-time holders still favor dividend growth. ENLC reports fairly low investor turnover in the past couple of years, and clearly a great many original MLP holders (i.e. older, wealthy Americans) have retained their holdings. We think if ENLC investors fully understood the improving coverage inherent in buybacks, they’d prefer them to an increased payout.

An anonymous Twitter contributor well-versed in the capital mis-steps of the sector ran a hilarious NCAA-style tournament of pipeline stocks, which was still ongoing at the time of our dinner (see MLP Humor — A Target-Rich Environment). Voters determined the result of each match-up, based on which visited the more egregious abuse on investors. This was a brief topic of conversation. ENLC progressed through the first two rounds, and must have been relieved to have been eliminated at the “Sour Sixteen” stage.

ENLC is an overweight long position across our portfolios. It’s cheap, with good growth prospects and we like the management. Dinner reaffirmed our conviction.

We are invested in ENLC, EPD, OKE and PAGP.

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

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

MLP Humor — A Target-Rich Environment

Humor can be a most effective weapon against your adversaries, especially when more extreme measures are unavailable.  MLP management teams have made many poor capital allocation decisions in recent years, providing a rich source of material for an observer armed with both wit and a deep knowledge of the sector’s history. On Twitter, such a combination exists in the anonymous Mr. Skilling, who has been aiming rapier-like thrusts at many of the industry’s worst offenders, to hilarious effect.

Inspired by the NCAA basketball bracket, he constructed a 64-team equivalent for present and past MLP managements. The winner of each match-up was decided by votes, with Mr. Skilling helpfully providing recent form, such as “total equity value destroyed”, number of distribution cuts, and the priceless “Ponzi Ratio” (equity raised divided by distributions paid out). This is one competition nobody wants to win, and any progress through the tourney presents an investor relations challenge.

Competitors were assigned to four regions, with names like “Corporate Governance? Never Heard Of It”. They were seeded, with the top seeds being assigned to the worst offenders. Perhaps this will lead to a new due diligence question (“What’s the highest seeded holding in your portfolio?”).

Prior to each match-up, Tweeted commentary set the stage.

$AMID

Some companies had achieved a head start by already going bankrupt – and Vanguard Natural Resources’ two bankruptcies gave them a clear edge.

$VNR

HiCrush (HCLP) showed an exquisite touch in fleecing their investors. They temporarily raised their distribution to an unsustainable level which threw off increased Incentive Distribution Rights (IDR) payments to the General Partner (GP). These IDR’s were then cancelled in exchange for new equity issued to the GP, before the distribution was then slashed.

$HCLP IDR takeout abuse
$HCLP
$HCLP IDR Buyout

Such a record would seem to be unassailable, but Linn Energy’s bankruptcy provided unanswerable competition by saddling their investors with an additional taxable gain for debt forgiveness on top of their worthless LP units.

$LINE

Failed companies should dominate such a tournament, but Targa Resources (TRGP) progressed to the “Sour Sixteen”, propelled by repeated poor investment decisions led by CEO Joe Bob Perkins of the now infamous “capital blessings” comment.

Mr. Skilling spares few, including Alerian who inducted Energy Transfer CEO Kelcy Warren into their Hall of Fame.

Kinder Morgan’s sale of their TransMountain Expansion also won an award for best acquisition, although there’s little doubt the Canadian taxpayer got the worse end of the deal.

Trans Mountain Pipeline

Hinds Howard, who follows the sector for CBRE Clarion Securities, was inspired to add this little gem.

The humor is biting, and entertaining if you’re not financially scarred by the miscreants. But beyond the hilarity there are a couple of takeaways. The traditional MLP-GP structure, under which MLP investors endured weak governance rights and paid IDRs to the GP, has always looked to us like the relationship between a hedge fund and the hedge fund manager.

It’s widely accepted that hedge fund investors have done poorly (see The Hedge Fund Mirage). This recognition is why we have long favored the GP versus the MLP, although few such situations remain. It’s also why we don’t invest in any MLP that’s paying IDRs. Our portfolios haven’t avoided poor stewards of capital, but in always being aligned with management we have sidestepped the worst examples listed above.

The other point is that the industry has changed substantially. Simplifications have removed the GP’s ability to direct their MLP into dilutive projects while increasing IDRs. Governance has improved with the conversion of many large MLPs into corporations. Projects are increasingly self-financed and leverage is coming down.

The sheer quantity of episodes of investor abuse reflect the opprobrium so widely earned, and yet reputations lag reality on the way down as well as on the way back up. Depressed valuations reflect the past, far more than the future of sharply growing cashflows.

Mr. Skilling worries that, “…the same clowns that destroyed value are still running these companies” but is “…more positive on the space now that most IDRs have been killed off.”

Investors who learn from past mistakes, amply displayed on Twitter, can exploit a sector still priced for the misdeeds of old while positioned for a much better future.

The final is on Monday, April 8th. Make your voice heard by voting.

We are invested in ET, KMI, TRGP. 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).

The Quiet Investors in Energy

The S&P Energy sector has delivered the worst returns of eleven sectors for four of the past five years. Reflecting investor disdain, energy is now around 6% of the S&P500, down by half in the past decade. Realizing the full potential of the Shale Revolution has demanded a lot of capital – over $1TN by one estimate. Management teams’ desire to grow has increasingly conflicted with investors’ insistence on greater cash returns. In midstream infrastructure this has been especially acute, with the traditional income-seeking MLP investor enduring multiple distribution cuts to support growth projects.

On Twitter, an anonymous, well informed energy investor created a humorous NCAA-type bracket to identify the most capital-destructive management team among publicly traded energy stocks. Each pairing is resolved through online votes, with the ultimate winner earning a most ignominious title. One comment asked if there was another sector with as wide a gap between management self-perceptions and those of investors.

Yet there’s a class of investor that continues to find energy attractive – private equity.

A recent presentation by S. Wil VanLoh Jr. of Quantum Energy Partners offered a useful perspective.

Public equity investors are repelled by the energy sector’s persistently low free cash flow, with profits too frequently plowed back into new production. By contrast, private equity (PE) funds with their locked up capital are drawn by the internal rates of return, which they find attractive. Their ability to outspend cashflow for several years as projects are developed can’t be matched by their public counterparts, whose investors are sensitive to quarterly earnings. Although this hasn’t led to any significant public companies being taken private, it has led to PE becoming a steadily bigger player in shale. They recognize that the U.S. has already won the shale race against the rest of the world.

Private Equity Views the Shale Revolution

Growing market share and increased geopolitical flexibility must surely lead to good investment returns. But around $1TN in capital has not all been well spent, and any sector recovery depends on management teams regaining the trust that has been lost.

Private Equity Views the Shale Revolution

The industry’s operating efficiencies are well known. Capex per well has been declining while output has soared. Pad drilling has brought scale and corresponding efficiencies, with rig productivity up 6X in the last five years. Since 2010, acquisition and development of shale resources by PE has grown from 10% to over half the total. PE rig count is estimated at 37%, up from 20% six years ago.

ROCE for Upstream E&P Companies

Nonetheless, the shrinking of the public equity investor appetite for energy has impacted PE, because it’s constrained their ability to exit via a sale of assets to a publicly traded company, or via an IPO. There were no MLP IPOs last year, illustrating that the public equity markets are closed to energy companies. So PE holding periods have gone from 2-4 years to 4-7.

Falling Free Cash Flow Hurts Valuations

Meanwhile, public companies are responding to calls for greater cash flow discipline by moderating growth capex and redirecting more cash back to investors through dividend hikes and buybacks. There are also signs that capex plans now adjust more quickly to altered circumstances than in the past. Several upstream companies lowered their planned spending during 4Q18 as oil slumped.

On the midstream side, Magellan Midstream (MMP) recently have shelved an expansion project because of insufficient shipper demand. Several projects are planned to increase capacity for the largest crude tankers, which require deepwater ports offshore. Perhaps concerned about overcapacity, Kinder Morgan pulled out of a JV with Enbridge to develop a deep water crude oil export facility, although the project is still expected to proceed.

A consequence of this new capital discipline is that public companies’ criteria for buying assets from PE owners include that they be FCF-positive, so as to maintain promised cash returns to stockholders. A positive NPV is no longer enough, which is forcing PE investors to develop their assets more fully than expected, taking up more time and capital.

Infrastructure funds, which often include midstream energy infrastructure in their mandate, raised a record $88BN in 2018, up from $75BN in 2017.  PE investors have been active in the pipeline sector. Blackstone invested almost $5BN in two deals with Targa Resources (TRGP) and Tallgrass (TGE). Funds managed by Carlyle, Stonepeak and Arclight have also committed capital.

Although the 2014-16 MLP price collapse continues to haunt investors, there is a chronic shortage of assets that can generate stable cashflows over two decades or more. The recent drop in U.S. ten year yields to 2.4% is one example. Ten year German Bund yields are negative again, and French oil giant Total issued perpetual bonds at 1.75%. PE investors buying infrastructure understand this better than public markets, and a publicly owned pipeline with a distributable cash flow yield above 10% looks like a mispriced asset. It’s why we think the sector has substantial room to appreciate.

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).

Deja Vu All Over Again for Pipelines?

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

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

REITS and Pipelines Move Together

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

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

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

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

REITS and Pipelines Part Ways

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

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

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

DCF Yields REIT vs AEITR

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

MLP Yield Spread vs. REITS

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

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

We are invested in EPD and short AMLP.

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

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

Pipelines’ New Look

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

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

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

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

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

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

See MLP Funds Made for Uncle Sam for more detail.

AMLP's Tax Burdened Performance

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

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

Pipeline Corporations Outperform MLPs

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

Corporations Are Less Risky vs MLPs

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

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

We are short AMLP.

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

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

4Q18 Energy Infrastructure Earnings Wrap Up

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

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

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

TRGP 4Q18 Earnings

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

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

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

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

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

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

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

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

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

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

We are invested in ET, PAGP, TRGP, WMB.

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

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

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