REITS: Pipeline Dividends Got You Beat

Long time MLP investors fondly recall the days before the Shale Revolution, when yield comparisons with REITs and Utilities made sense. This ended in 2014, when the energy sector peaked. Cumulative distribution cuts of 34%, as subsequently experienced by investors in the Alerian MLP ETF (AMLP), convinced income seeking investors that pipelines were a hostile environment.

During the 2014-16 collapse in crude oil, yield spreads on energy infrastructure blew out compared with sectors that were formerly peers. It might be the only period in history when companies have slashed distributions primarily to fund growth opportunities, and not because of an operating slump (see It’s the Distributions, Stupid!)

EBITDA vs Leverage

Several months ago, Bank of America published this chart showing that EBITDA for the sector grew steadily through the energy collapse, and leverage came down. Persistent weakness in the sector can best be explained by the betrayal of income-seeking investors. Distribution cuts were unacceptable to many, regardless of the reasons.

2019 should be the first year since crude oil bottomed at $26 per barrel that payouts will be rising (see Pipeline Dividends Are Heading Up). Because falling distributions are so clearly the reason the sector has remained out of favor, increasing payouts could provide the catalyst that will drive a strong recovery.

Income-seeking investors who return to the pipeline sector will find much to like. Funds From Operations (FFO) is a commonly used metric for REITs. It measures the net cash return from existing assets. The analogous figure for energy infrastructure businesses is Distributable Cash Flow (DCF).

We’ve found that comparing pipelines with real estate resonates with many readers. Differentiating between cash earned from existing assets and cash left over after investing in new assets is intuitive when applied to an owner of buildings.

As we showed in Valuing Pipelines like Real Estate, looking at Free Cash Flow (FCF), or net cash generated after new initiatives, doesn’t present an accurate picture if a company is investing heavily. And because dividends have been declining, it’s been hard for investors to get comfortable that current payouts are secure. Since neither FCF nor dividend yields have been enticing, capital has often avoided the sector.

MLPs commonly paid out 90% or more of their DCF in distributions, which left too little cash to fund the growth projects brought on by the Shale Revolution. Attractive DCF yields drew scant attention when payouts were declining, but a consequence of the sector’s loss of favor is that 2019 DCF yields are two thirds higher than for REITs.


Moreover, they’re set to grow faster. U.S. REIT investors can expect only 2% growth in FFO on a market-cap weighted basis (data from FactSet). We expect 2020 DCF for the American Energy Independence Index to jump by 10.3%. Improving cash flow supports rising dividends, which we expect will be up 10% this year and next (see Income Investors Should Return to Pipelines in 2019).

Much of this is the result of growth projects being placed into production. A pipeline doesn’t generate any cash until it’s completed, so virtually all the expenditure occurs up front. MLP investors suffered the distribution cuts necessary to help fund this – we’re now starting to see the uplift to cashflows. It’s further helped by a likely peak in growth expenditures (see Buybacks: Why Pipeline Companies Should Invest in Themselves, chart #4).

MLP Yield Spread vs. REITS

Once REIT investors return to comparing their holdings with energy infrastructure, they’re going to find strong arguments in favor of switching. They’ll find they can upgrade both their income and growth prospects by moving their REIT holdings into pipelines. MLP yields are historically wide compared with REITs, and 85% of the last decade the relationship has been tighter. Just remember to invest in broad energy infrastructure and not to limit your investment to MLPs (see The Uncertain Future of MLP-Dedicated Funds). Four of the five biggest pipeline companies are corporations, not MLPs, which nowadays represent less than half the sector.

Top 5 Holdings REITs vs Pipelines

The Shale Revolution is a fantastic American success story. The Energy Information Administration expects U.S. crude oil output to reach 13 million barrels per day (MMB/D) next year. The U.S. continues to gain market share. It’s estimated that Saudi Arabia needs a price of at least $80 per barrel to finance their government spending. To this end, the Saudis are cutting production to below 10 MMB/D. They’re slowly ceding market share in the interests of higher revenues.

Investors have little to show for allocating capital towards the Shale Revolution. That is about to change. The American Energy Independence Index is up 18% so far this year, easily beating the S&P500 which is up 10%. The sector is starting to feel the love.

Join us on Friday, February 22nd at 2pm EST for a webinar. We’ll be discussing the outlook for U.S. energy infrastructure. The sector has frustrated investors for the past two years, but there are reasons to believe improved returns are ahead. We’ll explain why. To register please click here.

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 (

American Energy Independence is Imminent

The U.S. Energy Information Administration (EIA) recently published their 2019 Annual Energy Outlook. Whenever your optimism on the prospects for U.S. energy infrastructure waivers, this will restore your confidence. The outlook for domestic energy production is bullish, and in many cases more so than a year ago.

For example, in their 2018 report, the EIA’s Reference Case projected that the U.S. would eventually become a net energy exporter. Now, thanks to stronger crude and liquids production, they expect that milestone to be reached next year.

EIA Annual Energy Forecast 2018 vs 2019

The expected improvement in America’s balance of trade in liquids is dramatic, especially compared with last year’s report. It’s equivalent to an additional 2.5-3.0 Million Barrels per Day (MMB/D) of output.

EIA Net Energy Trade 2018 vs 2019
EIA LNG Projections

Liquified Natural Gas (LNG) exports are also set to jump sharply, and overall natural gas exports are projected to more than double over the next decade. This is driven by growing Permian crude output, which comes with natural gas as an associated product from oil wells. It’s why flaring is common today, because the needed takeaway infrastructure for natural gas remains insufficient. Mexico’s own infrastructure to import natural gas for electricity generation is still being developed, and new LNG export facilities will provide further demand.

The middle chart in the panel below highlights the correlation of natural gas output with the price of crude oil. This is because the EIA assumes that higher crude prices will stimulate more Permian oil production, producing more associated natural gas.

EIA Associated Natural Gas Production

Although use of renewables to generate electricity will grow, they’re still expected to provide less than one third of all electricity even in 30 years. Almost all the growth will be in solar, which works best in southern states that receive more sun. Although my state, New Jersey, is subsidizing residential solar roof panels, they’re not much use in winter. This is especially so because electricity demand generally peaks twice a day, around breakfast and dinner, when people are leaving for work/school or returning home. At this time of year in the northeast, it’s dark during both peak periods. Only half the days are even partly sunny, with cloud cover rendering solar ineffective on the rest.

Moreover, the bucolic, leafy suburbs enjoy plenty of summer shade which can also block the sun from reaching solar panels. Widespread deployment of solar will require cutting down some big old trees that impede southern exposure.

EIA Renewables Growth

Large-scale battery technology doesn’t exist to store midday solar power for use at peak times Therefore, intermittent sources of power (also including wind) require substantial excess capacity, as well as baseload power that’s always available. Environmental activists haven’t all accepted this yet, but natural gas remains the big enabler for increased solar power.

Some extremists desire a carbon-free world, but that Utopian objective ignores the symbiotic relationship natural gas and solar/wind share. They’re complimentary energy sources. Opposing all fossil fuels impedes the growth of intermittent energy sources and forces more excess, redundant capacity. The Sierra Club and those who share their views seek impractical, purist solutions that will struggle both economically and politically.

Intermittent Solar Needs More Natural Gas

Natural gas is in many ways a bigger U.S. success story than crude oil. Its abundance ensures continues low prices, supporting both exports as well as cheaper domestic electricity than most OECD nations. Because the U.S. has some of the lowest-priced natural gas, different scenarios nonetheless offer fairly uniform growth in output. Natural gas prices are less susceptible to the cycles of crude oil, which combined with America’s advantages noted above makes investing in its infrastructure more attractive.

EIA Steady Rise in Natural Gas Production

There’s plenty in the EIA’s 2019 Outlook to support a bullish view for midstream energy infrastructure. Financing growth projects has weighed on stock prices for several years, leaving investors frustrated and complaining about insufficient cash returns. But if the peak in growth capex peak is behind us, as looks likely, free cash flow and payouts should start increasing again. Cash flow yields on the sector average 12% before growth capex. This is analogous to the funds from operations metric used in real estate, but double the yield on the Vanguard Real Estate ETF (VNQ), for example. REIT investors should take note.

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 (

MLP-Dedicated Funds See Increasing Redemptions

Fund flows will always beat fundamentals. This was rarely more evident than in the performance of MLPs last year. Throughout 2018, earnings reports from pipeline companies were generally in-line, with positive guidance. Operating results contrasted with stock prices, which confounded investors and management teams as they sagged. Negative sentiment worsened late in the year, not helped by broader market weakness caused by trade friction, Fed communication mis-steps and the Federal government shutdown.

JPMorgan calculates that there is $38BN invested in open-ended MLP and energy infrastructure products, across ETFs, mutual funds and exchange traded notes. In spite of peaking in August 2014, the sector saw inflows during the three subsequent years. This reversed dramatically late last year, as retail investors liquidated holdings. November and December saw $1.9BN in net outflows, enough to depress prices regardless of news.

Energy Infrastructure 5 Years of Inflows
Energy Infrastructure Q418 Fund Outflows

Looking back over several years, the period looks like a selling climax, with no similar episodes visible.

Conversations with redeeming investors revealed many unwilling sellers. Taking tax losses motivated some, while others confessed to exhaustion with poor stock returns in spite of apparently improving fundamentals. Like all money managers in the sector, we were faced with little choice but to sell on behalf of such clients.

Interestingly, MLP-dedicated funds received a disproportionate share of redemptions. This makes sense, given their flawed tax structure (see MLP Funds Made for Uncle Sam). The drag from paying corporate taxes on profits has been substantial in past years of good performance.

MLP Dedicated Fund Outflows

Hinds Howard of CBRE Clarion Securities recently noted that, “MLPs are less than half of the market cap of North American Midstream, and the number of MLPs continues to shrink.  This is ultimately a good thing for those public players that remain, who will achieve greater scale and competitive bargaining power.” Many big pipeline operators are corporations, so an MLP-only focus makes less sense because it omits many of the biggest operators.

Howard went on to add that, “…it has significant ramifications for the asset managers with funds designed specifically to invest in MLPs.” This is because such funds are faced with an unenviable choice between sticking with a shrinking portion of the overall energy infrastructure sector, or dumping most of their MLPs in order to convert to a RIC-compliant status (see The Uncertain Future of MLP-Dedicated Funds). These are additional marketing headwinds on top of last year’s weak returns.

2018 fund flows suggest that investors in MLP-only funds are beginning to realize this problem, and are acting accordingly. The biggest such funds saw $2.6BN in net outflows during 2018’s latter half, 88% of the total, although they only represent 55% of the sector’s funds. Investors redeemed from tax-burdened MLP funds at almost twice the rate of the overall sector.

Many feel the sector is due a good year, and if it is, corporate taxes will lead to correspondingly high expense ratios for MLP-focused funds.

Energy Infrastructure Open Ended Fund Flows

Early signs in 2019 are encouraging. The outflows abruptly ended at year-end, and investors we talk to are turning more positive. Strong January performance has helped. From where we sit, inflows dominate and new investor interest has increased sharply. Valuations remain very attractive, with distributable cash flow yields of 11%. We expect dividend growth in the American Energy Independence Index of 7-10% this year and next. Momentum seems to be turning.

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 (

Kinder Morgan: Great, But Stick to Pipelines

Kinder Morgan (KMI) kicked off pipeline company earnings last week. Their results contained no big surprises. Distributable Cash Flow (DCF) for the year came in at $4.73BN, up 5.5% versus 2017’s $4.48BN. Leverage finished the year at 4.5X (Net Debt/Adjusted EBITDA). KMI has argued previously that their diversified business could sustain a 5.0X ratio, something not always supported by the rating agencies. The sale of their TransMountain pipeline to the Canadian government (see Canada’s Failing Energy Strategy) created a cash windfall that they used to pay down debt. KMI now expects to remain at 4.5X for this year.

Like many investors, we think KMI’s continued investment in its CO2 business is a drag on value. Because Enhanced Oil Recovery (EOR) doesn’t generate the same recurring revenues as pipelines and terminals, we think the market assigns little value to the approximately 10% of DCF this segment represents. Moreover, the $1.6BN in capex planned for CO2 is 28% of the total backlog and three times what the company spent buying back stock in 2018. The commodity sensitivity of this segment is an unwanted distraction. If they can’t sell it, they should at least reduce the new cash deployed there.

Using a real estate analogy — if building and running pipelines is like constructing and owning rental property, then EOR is more akin to building houses and flipping them. For flippers, what matters is the net profit and not proceeds from each sale. Rental income (i.e. pipeline tariffs) are stable; profit from building and selling properties (i.e. oil production) is not. So DCF is the wrong valuation metric for the CO2 business, and basing a dividend on such unpredictable cash flows is inappropriate.  Midstream investors are not fooled by this, which we believe explains KMI’s persistent low valuation.

The uncertain recurring nature of the CO2 business causes many to overlook it. This lowers the DCF yield by about 1/10th to 11.2%, which is nonetheless still very attractive.  Considering KMI’s incredible position in natural gas pipelines, the market is applying a hefty discount.  When asked, management typically responds that selling its CO2 business would be dilutive, because in a sale it would command a lower EV/EBITDA multiple than KMI as a whole. But we think the company’s valuation remains burdened by a business segment that doesn’t obviously belong there. We were happy to see reports late on Thursday that KMI was exploring its possible disposition.

Putting that aside, we still think KMI is cheap. DCF is analogous to Funds From Operations (FFO), a common metric used in real estate and one we discussed in a video last year (see Valuing Pipelines Like Real Estate). It’s the cash generated from their existing business before growth projects. KMI is forecasting $5BN, or $2.20 per share in DCF for 2019, which is a 12.5% yield (11.2% ex the CO2 segment). However, they’re planning to invest $3.1BN in new projects during the year, and since this will be funded internally their Free Cash Flow (FCF) will be lower by this amount.

KMI’s $0.80 annual dividend is expected to rise to $1, a 5.7% yield. The company has projected another increase in 2020, to $1.25. Yield-seeking buyers will increasingly take note.

KMI Payouts

They will need to forgive the past. Prior to 2014, KMI and its former MLP Kinder Morgan Partners (KMP) were owned for income. The conflict between a high payout ratio and ambitious growth plans resulted in the absorption of KMP’s assets by KMI. In the process, KMP units were each replaced with 2.2264 KMI shares. KMI’s $2 dividend worked out to be $4.45 per KMP unit, 20% less than the $5.58 they were receiving previously.  There was a cash payment of $9.54, but KMP unitholders also suffered that infamous adverse tax outcome, which many regarded as more costly.

Moreover, the $2 KMI dividend, which was promised to grow at 10% annually, was instead slashed by 75% a year later.  For many companies, such a dramatic reversal would reflect poorly on the finance function and result in management changes. However, KMI’s CFO Kimberly Dang was subsequently promoted to president. Sell-side analysts won’t highlight this for fear of losing access, but that track record isn’t a positive for the stock. Regrettably for the company’s founder, being “Kindered” is now a widely used term when your promised distributions lose out to a company’s growth plans.

The Shale Revolution continues to be a fantastic success story for America, but increasing oil and gas production requires new infrastructure to gather, process, transport and store it. Like many companies afterwards, KMI ultimately chose to direct more cash towards growth projects and correspondingly less to shareholders.

Therefore, the drop in growth capex is a critical development. Five years ago as midstream energy infrastructure embraced a growth business model, it soon became clear this was incompatible with high payout ratios, and the income-seeking investors they had sought. We are now coming down the other side of the capex mountain, which is supporting a resumption of dividend growth. For KMI investors it’s been an unpleasant journey, but a DCF, or FFO yield of around 11% (after backing out the CO2 business) is substantially greater than REITs, a sector with which MLPs used to be compared.

In 2014 KMI had a five year backlog of $18BN in projects under way, which was financed in part by the reduced dividends. Today they expect $2-3BN in annual growth capex, and have $5.7BN in projects at various stages of completion.

KMI’s rising dividend should support growing realization that energy infrastructure stocks are returning more money to shareholders. Its yield is rising to a level that should attract new income-seeking investors willing to forgive past mistakes by management.

We are invested in KMI.

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 (

Lose Money Fast with Levered ETFs

A few years ago Vanguard invited me to their campus to give a presentation on my just-published book, The Hedge Fund Mirage. Vanguard’s business model is the antithesis of the hedge fund industry, and they were curious to hear from that rare breed, a hedge fund critic. The company’s frugal culture runs deep. As I joked during my presentation, the only German car in the parking lot was mine. Lunch was in the “galley” (cafeteria), where my host reached into his pocket to buy my sandwich and fruit cup. This is a company whose products are usually appropriate ways to access a desired asset class.

So it was in character for Vanguard to recently ban leveraged and inverse ETFs from their brokerage platform. Such products have long been criticized because their only plausible use is for extremely brief holding periods of a few days or less. Because of their daily rebalancing, over time compounding drives their value to zero. To visualize this, imagine if you owned a security which rebalanced its risk daily so as to maintain constant market exposure. A 10% down move followed by a 10% up move would leave you down 1%. Time and volatility work against the holder, except for those able to successfully predict the daily fluctuations and time their trades accordingly. Only those seeking profits in a hurry, or trying to temporarily hedge more risk than they’d like, find them attractive. Neither resembles a long-term investor.

Vanguard’s philosophy prevents creating leveraged or inverse ETFs of their own, but now they’ve taken a logical further step to increase the distance between their clients and long term value-destroyers. They correctly noted that such products are, “generally incompatible with a buy-and-hold strategy.”

This is a popular area, with soaring volumes in recent years. It’s another example of the excessive focus on short term market direction. Consumers of financial news want to know where the market’s going today, and media outlets duly respond. But prospectuses routinely warn that leveraged ETFs will probably decline to zero over time, which means the average holder will lose money. On this basis, one might think the SEC would find banning them easily defensible. So far, while individual commissioners have voiced concern, they haven’t moved further. Finance is not short of regulation, and a philosophy that allows consumers to decide appropriateness for themselves allows innovation, and is more right than wrong. However, it works best when the products financial companies offer to their least sophisticated, retail clients are designed with good intentions. Hedge funds and other sophisticated investors can be expected to properly understand how to use leveraged and inverse ETFs – like prescription medication, their availability should be carefully controlled.

We’ve been critics of these products for years (see Are Leveraged ETFs a Legitimate Investment? from 2014 as well as The Folly of Leveraged ETFs and recently FANG Goes Bang).

Leveraged ETF AMJL vs AMZX

In May 2016 Credit Suisse issued a 2X Leveraged ETN linked to the Alerian index. Since then it’s down 55%, while the index is down 12% (including distributions).  Losses are only limited to two times the index over very short periods. This type of long term result is common. It’s unrelated to the index and invariably worse, which Credit Suisse, and Alerian (who allowed their index to be licensed) would have known at the outset. Either name attached to an investment should give the buyer pause. It’s why these products shouldn’t be offered to retail investors.

Energy infrastructure remains one of the most attractively valued sectors around. The American Energy Independence Index yields 6.75%, and we expect dividends to grow 6-7% this year. This is attractive enough for the long-term investor, and isn’t available as a leveraged product.

On Wednesday, January 16th at 1pm Eastern we’ll be hosting a conference call with clients. If you’re interested in joining, please contact your Catalyst wholesaler, or send an e-mail to

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 (

Are Computers Exploiting MLP Investors?

Energy infrastructure roared higher during the first six trading days of January. After four days, the sector had recovered December’s losses. Two days later, it had almost recouped all of 2018. It was a complete reversal of last month, when slumping equity markets dragged pipeline stocks lower.

It’s looking increasingly likely to us that automated trading strategies relying on complex algorithms (“algos”) are at least part of the reason.

Last year MLPs had already been laboring under the weight of serial distribution cuts. For example, AMLP’s payout is down by 34% since 2014. Incidentally, this must be the worst performing passive ETF in history. Since inception in 2010, it has returned 4% compared to its index of 25%. Its tax-impaired structure is part of the reason (see Uncle Sam Helps You Short AMLP).

For the first nine months of last year, crude oil and energy infrastructure moved independently of one another. Investors who painfully recall the 2014-16 energy sector collapse complained that rising crude prices didn’t help, but as the chart shows, they rallied together in the Spring but parted company in late Summer as the oil market started to anticipate the re-imposition of sanctions on Iran. Crude and pipeline stocks are intermittently correlated, because their economic relationship is weak. Crude sometimes drives sentiment, which can quickly change.

Energy Infrastructure Sometimes In Step with Crude Oil

However, when crude dropped sharply following the Administration’s waivers allowing most Iranian exports to continue, energy infrastructure followed. Pipeline company management teams routinely show very limited cash flow sensitivity to commodity prices, and 3Q18 earnings reported in October/November were largely at or ahead of expectations. Nonetheless, an algorithm incorporating the 2014-16 history would expect MLPs to follow crude when it drops sharply, and would act accordingly. Trading systems bet on falling MLPs following crude, and sold.

In late December crude reversed, and trading systems at a minimum are closing out short pipeline positions if not going the other way. Hence the blistering early January recovery. The fundamentals were good in December, and remained so in January. Any change was imperceptible.

This is conjecture. It’s impossible to obtain hard data to support or refute this theory of market activity. So consider our perspective as a money manager in the energy infrastructure sector, in daily contact with clients and potential investors discussing the outlook. In December, callers were frustrated. The apparent disconnect between fundamentals and stock prices was confusing, troubling. What were they overlooking? What were we missing? Many held, but some didn’t. Frustrated at losses they couldn’t explain, having lost faith with repeated bullish analysis, the sector saw more outflows than inflows. Potential buyers noted compelling values, but usually were dissuaded by continued sector weakness. Unable to comprehend the inability of good financial performance to boost prices, many opted to wait. Tax loss selling towards the end of the year exacerbated.

The turn of the calendar coincided with a modest bounce in crude oil, as reports surfaced that the Saudis were sharply reducing crude exports to the U.S. Current prices are creating for them a substantial fiscal gap.

Conversations with clients and prospects have completely turned. Now callers want to know if there will be a pullback. Is the rally for real? Flows have also reversed. One day last week inflows to one of our funds outweighed outflows by 100:1. In December there were no buyers. In early January there are no sellers.

I was prompted to consider events in this light by a recent article in the Financial Times (Volatility: how ‘algos’ changed the rhythm of the market). Philosophically, I’m inclined to believe that automated trading simply does what humans do, just better and more cheaply. However, there is a less benign feature in that algos are also exploiting the inefficiences of humans. Michael Lewis showed this in Flash Boys by examining how high frequency trading systems will see market orders placed and race to snatch the best price before the limit order is executed. This happens in fractions of a second. But humans can also be outwitted over longer periods. December saw the biggest ever monthly outflows from mutual funds, capping an unusual year in which almost every market was down.

There was some bad news. The trade dispute with China is slowing growth there, and S&P500 earnings forecasts are being revised lower. The government is shut down. Fed chairman Powell sounded more hawkish before walking back his comments (see Bond Market Looks Past Fed). But these developments scarcely seem to justify record mutual fund outflows. There have been far worse environments for stocks.

Hedge fund veteran Stanley Druckenmiller said, “These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me.” Philip Jabre closed his eponymous hedge fund, complaining, “…the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerized models.”

The Financial Times quoted a senior JPMorgan strategist as saying that, “…we just have to accept that equity markets are almost fully automated.” JPMorgan estimates that only 10% of trading is generated by humans.

The Wall Street Journal reported that trend-following trading systems shifted “…from bullish to bearish to a degree not seen in a decade, according to an analysis of algorithms that buy or sell based on asset-price momentum.”

The WSJ also blamed volatility in commodity markets on computerized trading, citing a report that “…Goldman Sachs attributed the recent volatility to algorithmic traders exerting more influence in the oil market.”

The growth in algorithmic trading seems to be coinciding with a drop in discretionary trading by humans, which probably reflects that computers are beating humans in certain areas.

On one level, algos are designed to exploit human frailties by anticipating them. Perhaps they even cause them. It seems many people had little reason to sell in December beyond fear of losing money. Successful algos by definition attract capital, increasing their ability to move markets and hunt for more inefficiencies. Humans, at least those who adjust their positions too frequently, are becoming prey. One result could have been systematic shorting of pipeline stocks in response to crude’s sharp drop, because it worked in 2014-15. Sector weakness certainly couldn’t be traced back to recent earnings reports. Investors who sold during this time because they tired of losing money added to the downward pressure, reinforcing the trend. This would also have provided confirmation to the algorithms that the signal worked.

Since computerized trading isn’t going away, survival for the rest of us lies in being less sensitive to market moves. Examining fundamentals and staying with a carefully considered strategy that doesn’t rely on the market for constant confirmation of its correctness is the human response to algos.

Energy infrastructure remains attractively valued. Free cash flow yields before growth capex (i.e. Distributable Cash Flow) are over 11%. We estimate dividends will grow on the broadly based American Energy Independence Index this year by mid to high single digits. The long term outlook for the sector remains very good.

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 (

2018 Lessons From The Pipeline Sector

Blog pageviews and comments help us gauge how relevant our topics are. Writing is more enjoyable when readers engage. This blog gets reposted across many websites, including Seeking Alpha and The feedback from subscribers often leads to a useful dialog and informs later choice of topics. Below are the themes that resonated in 2018.

The name Rich Kinder strikes a raw nerve with many. Kinder Morgan: Still Paying For Broken Promises revealed the depth of feeling among many investors. This is because Kinder Morgan (KMI) began the trend towards “simplification”, which came to mean distribution cuts and an adverse tax outcome. To get a sense of the betrayal felt by some, peruse the comments on the blog post on Seeking Alpha where readers can let rip in a mostly un-moderated forum. It becomes clear that cutting payouts has severely damaged appetite for the sector, something we realized through this type of feedback.

KMI Promises Made Promises Kept

A similar post examined how Energy Transfer (ET) had lowered payouts for certain classes of investor, (see Energy Transfer: Cutting Your Payout Not Mine) and drew an even bigger response (272 comments). ET CEO Kelcy Warren is a controversial figure. Our post showed that while original Energy Transfer Equity investors had avoided distribution cuts, holders of Energy Transfer Partners, Sunoco Logistics and Regency Partners hadn’t fared so well.

ETEs Distributions Climb While its Affiliate MLPs Decline

Kelcy Warren inspired our most colorful graphic in August, when he said, “A monkey could make money in this business right now.” (see Running Pipelines Is Easy). ET’s stock has lost a quarter of its value since then, even though their financial performance has justified his comments.

Last year was a testing one for those convinced the Shale Revolution should generate investment profits. In Valuing MLPs Privately; Enterprise Products Partners we laid out how a private equity investor might value the biggest publicly traded MLP. It wasn’t controversial, but many readers communicated their appreciation at this type of analysis.

The problem for the sector has always been balancing high cash distributions with financing growth projects. We think current valuations focus too much on Free Cash Flow (FCF) without giving credit to Distributable Cash Flow (DCF). FCF is after growth capex, while DCF is before. We illustrated this with a short video (see Valuing Pipelines Like Real Estate).

Early in the year we wrote several blog posts highlighting the tax drag faced by most MLP-dedicated funds. Because they pay Federal corporate taxes on investment profits, 2018’s bear market didn’t expose their flawed structure the way a bull market will. We won’t repeat the argument here, but it’s laid out in MLP Funds Made for Uncle Sam.

A related topic we covered several times was the conundrum facing MLP-only funds, given that many big MLPs have converted to regular corporations. MLP-only funds can no longer claim to provide broad sector exposure, since they omit most of the biggest North American pipeline companies. But the funds themselves can’t easily broaden their holdings beyond MLPs, which creates some uncertainty for their investors. We explained why in Are MLPs Going Away? and The Alerian Problem.

We returned to the tension between using cash for growth versus distributions in Buybacks: Why Pipeline Companies Should Invest in Themselves. The industry continues to reinvest more cash in new infrastructure than is justified by stock prices. In many cases, share repurchases offer a better and more certain return than a new pipeline. Trade journals are full of breathless commentary on the need for more export facilities, more pipelines, more everything. It’s not pleasant reading for an investor, but this is the world inhabited by industry executives. More mention of IRR would be welcome. Pipeline investors are hoping that the Wells Fargo chart showing lower capex in the future will, finally, be accurate.

Midstream Industry Forecasts Peak in CAPEX

Fortunately, there are signs of better financial discipline. Leverage continues to drop and dividend coverage is improving, which will support a 6-8% increase in dividends on the American Energy Independence Index in 2019. As the year unfolds, we expect investors to cheer a long overdue improvement in returns.

We are invested in ET and KMI.

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 (

Income Investors Should Return to Pipelines in 2019

MLPs have become more attractively priced compared with other income-oriented sectors. One way to see this is to compare the trailing four quarter yield. REITs and utilities have remained within a fairly narrow range, while MLPs rose sharply during the 2014-15 oil collapse. After a partial recovery, weakness over the past year or so has caused MLP yields to drift higher again.

MLP Yields on the Rise


For many years prior to the 2014 sector peak, MLP yields were around 2% above utilities. Currently, they’re around 5% wider. This ought to attract crossover buying from income-seeking investors, switching their utility exposure for MLPs, but so far there’s limited evidence of this happening. Although the yield advantage over REITs isn’t quite as dramatic, the same relative value switch exists there too.


The broad energy sector has remained out of favor. MLPs used to track utilities and REITs fairly closely until 2014 when they followed energy lower. However, even compared with energy, midstream infrastructure remains historically cheap. Research from Credit Suisse shows that on an Enterprise Value/EBITDA basis, pipelines are the cheapest vs the S&P energy sector they’ve been since 2010.

Midstream Cheap vs Historical Valuation

The Shale Revolution has challenged the MLP model in ways that few anticipated. Increasing U.S. output of crude oil, natural gas liquids and natural gas is creating substantial benefits for the U.S. Improved terms of trade, greater geopolitical flexibility and reduced CO2 emissions underpin America’s greater willingness to buck the global consensus. However, investors are still waiting for the financial benefits. This is partly because the capital investments required have demanded more cash. E&P companies had to fund investments in new production, which drew criticism that they were over-spending on growth. Similarly, MLPs pursued many opportunities to add infrastructure for transportation, processing and storage in support of new production. All this left less cash to be returned to investors through buybacks and dividends. It remains the biggest impediment to improved returns.


Unlike MLPs, both utilities and REITs have both been increasing dividends. Even the energy sector has raised payouts, although this was achieved in part through less spent on stock buybacks, which has led their investor base to insist on improved financial discipline. MLPs have both increased cash flows and lowered distributions.  Oil & gas executives seem unable to turn down a growth project.

By contrast with the income sectors with which MLPs used to compete, they have been lowering dividends. This makes yield comparisons less reliable, and likely explains why there’s been little evidence of shifts away from lower-yielding, traditional income sectors.

It’s why the biggest pipeline companies have dropped the MLP structure in favor of becoming corporations, so as to access the broadest possible set of investors. However, that hasn’t always worked out either, as the history of prior distribution cuts continues to weigh on sentiment. Williams Companies (WMB) is an example of a corporation that combined with its MLP, Williams Partners (WPZ). WMB CEO Alan Armstrong claims to be puzzled by persistent stock weakness. Meanwhile, legacy WPZ investors well recall the multiple distribution cuts they endured along the way (see Pipeline Dividends Are Heading Up).

In our experience, one of the issues that makes current investors nervous and gives new ones pause is that they don’t understand the continued weakness when volumes are up and management teams bullish. In December most sectors were down sharply, and global growth concerns depressed the energy sector along with most others. But for most of 2018 and certainly the second half, the disconnect between strong operating performance and poor security returns has perplexed many.

We’ve sought to explain this, and regular readers will know we’ve concluded that reduced distributions are the most important factor. The investor base was originally drawn for stable income, which in recent years MLPs have failed to provide. The Shale Revolution, perversely, has so far been a lousy investment theme even while it’s been terrific for America.  The charts in this blog post present a narrative now familiar to many.

Next year we expect rising dividends for the companies in the American Energy Independence Index to draw increasingly favorable attention to the sector. Although the MLP model no longer suits most of the biggest operators in the industry, midstream energy infrastructure offers compelling value. The best way to participate is by investing in the biggest companies, which are mostly corporations but do include a few MLPs. When the sector begins its recovery, it’ll start from far below fair value.

We are invested in WMB.

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

SL Advisors is also the advisor to an ETF (

Pipeline Dividends Are Heading Up

For investors who seek despondent sellers, look no further than energy infrastructure in late 2018. The Alerian MLP Index made its all-time high way back in August 2014. It currently sits 43% lower (including dividends). Barring a strong recovery in the last days of December, returns for three of the past four years are negative. Not coincidentally, MLP distributions are down for their fourth straight year. The Alerian MLP ETF (AMLP) has cut payouts by 34%, with its most recent one last month. Investors don’t want dividend cuts, they want dividend hikes – and in 2019 they will see them.

The shift of MLP Distributable Cash Flow (DCF) from distributions to funding growth projects has been well documented (see Will MLP Distribution Cuts Pay Off?). Growth capex (i.e. where that money went) dipped in 2016 but has been robust since then. Valuations continue to be more reflective of Free Cash Flow (FCF), which is after capex, whereas we think DCF (before capex) is more relevant (see Valuing Pipelines Like Real Estate). But investors are skeptical that cash formerly paid out is being well spent, and resentful of the dozens of cuts. Rising payouts should help.

Pipeline company earnings calls are full of positive reports with optimistic guidance. Business has rarely been this good. In August, Energy Transfer (ET) CEO Kelcy Warren memorably said, “A monkey could make money in this business right now.” (see Running Pipelines is Easy). Business conditions have only improved since then. In November, ET reported another strong quarter, beating Street estimates of EBITDA by 11%. Yet ET’s stock slumped, and is down 33% from its late July “business is easy” level, even though that description seems accurate.

No other metric explains sector performance as well as the path of dividends (or distributions for MLPs).

WMB Quarterly Distributions

It’s rare for an industry to cut dividends when profits are growing, but that’s exactly what this sector has done. Falling dividends are so often associated with poor operating performance that investors reasonably equate the two – especially yield investors. Pipeline management teams consistently report on terrific business conditions and lament their stock’s low valuation. Part of the reason is that management teams too often invest in new projects rather than buying back stock. Buybacks with DCF yields of 14% and higher must surely be more compelling (and less risky) than all but the most attractive new investments. It’s no wonder investors question their judgement.  Williams Companies (WMB) CEO Alan Armstrong recently said, “I don’t recall a time in my years in executive management when the business has been this healthy but the equity markets so poorly reflecting that.”

While business is booming and valuations are very attractive, Alan Armstrong and others still fail to appreciate (or at least don’t acknowledge) the crushing effect dividend cuts have had on investor appetite for their stocks. No other explanation fits the facts as well. Some blamed crude oil for the 2014-16 collapse, but MLPs only modestly participated in the subsequent crude rally. Recently we read an analysis that attributed stock weakness to rising leverage, but leverage peaked in 2016 at around 5.5X Debt/EBITDA and is comfortably heading lower. We estimate that our portfolio companies’ will exit next year at 4.1X, comfortably within the range that prevailed before the 2014 MLP market peak.

EBITDA vs Leverage

For almost a decade, Williams Partners (WPZ) investors were trained to expect gently rising distributions that came with a tax deferral and a K-1. This happy arrangement was abandoned when Shale Revolution growth opportunities presented themselves. The first cut came when WPZ combined with Access Midstream (ACMP), formerly Chesapeake’s midstream business before it was spun out. WPZ adopted the lower, ACMP payout which resulted in an effective cut for legacy WPZ holders. Two years later, partly due to concerns about leverage, WPZ imposed a second outright cut. The final one came when WPZ was folded into Williams Companies (WMB), in a “simplification”. WMB’s lower payout was applied to WPZ holders, along with a tax bill on recaptured income.

Long-time WPZ investors have endured a 53% cut in their payouts, which are back to the levels of 2006. Having been taught to focus on distributions and ignore market gyrations, they must find Alan Armstrong’s upbeat comments incongruous if not insulting.

Nonetheless, Alan Armstrong is right that business is good. It’s just that he and his peers have so mistreated their investors that his enthusiasm is less infectious than he might like.

A useful perspective on valuations is to compare pipeline companies’ current EV/EBITDA premium to the energy sector versus its long term average. Even by the unloved standards of the energy sector, midstream infrastructure is historically undervalued.

Midstream Stocks Undervalued

The American Energy Independence Index (AEITR) includes North America’s biggest pipeline companies, and is 20% weighted to MLPs. Dividends paid by corporations have been more reliable than MLPs; 2018 dividends on the index are up 7%, following a 3% increase last year. By contrast, dividends on the Alerian MLP and Infrastructure Index, as represented by its index fund AMLP, are down 6% following a 16% drop in 2017. Since MLP payouts are a bigger portion of their available cash flow, they had farther to fall. But the limited investor base (largely U.S. individual investors) has inhibited their flexibility in managing cash.

As a result, many large MLPs have converted to corporations, so an MLP-only view of energy infrastructure (as with the Alerian MLP Index for example), fails to fully represent the sector. Moreover, MLP investors invest for income, which has made them an unreliable source of capital when their income is being cut.

In 2019 we expect AEITR dividends to grow high single digits. MLP distributions should also begin growing for the first time since 2014, although not by as much. Corporations generally offer faster, more reliable growth.

We wish all of our readers a Happy Christmas and holiday season. Enjoy the time with family, and we’ll all look forward to a rebound in 2019.

We are invested in ET and 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 (


Buybacks: Why Pipeline Companies Should Invest in Themselves

Weakness in the pipeline sector over the past couple of years has caused soul-searching and changes to corporate structure. Incentive Distribution Rights (IDRs), which syphon off a portion of an MLP’s Distributable Cash Flow (DCF) to the General Partner (GP) running it, have largely gone. Many of the biggest MLPs have abandoned the structure entirely, leaving its narrow set of income-seeking investors to become corporations open to global institutions.

The debate among investors, management and Wall Street about how to unlock value received some useful ideas recently from Wells Fargo. In a presentation titled The Midstream Conundrum…And Ideas For How To Fix It, they make a persuasive case that stock buybacks offer a more attractive use of investment capital than new projects.

This would be a significant shift for MLPs. As recently as five years ago, they paid out 90% or more of their DCF to unitholders and GP (if they had one). The Shale Revolution was only beginning to demand substantial new infrastructure, so they had little else to do with their cash. New projects were funded by borrowing and by issuing equity through secondary offerings.

Shale plays were in regions, such as the Bakken in North Dakota and the Marcellus in Pennsylvania/Ohio, inadequately serviced by pipelines. This broke the model, because the amounts of investment capital required grew substantially. The capital markets loop of paying generous distributions while simultaneously retrieving much of the cash through new debt and equity was no longer sustainable. Dozens of distribution cuts and lower leverage followed, leading to projects being internally financed. This is the new gold standard for the sector – reliance on external capital to fund growth is out.

Wells Fargo takes this logic a step further, asking why excess cash always needs to be reinvested back in the business rather than returned to investors via buybacks. In spite of professed financial discipline, midstream management teams invariably find new things to build, all expected to be accretive (i.e. return more than their cost of capital). Pipeline companies are not alone – the entire energy sector has been dragged by investors to prioritize cash returns over growth. But MLPs rarely buy back stock. Free of a corporate tax liability, MLP distributions aren’t subject to the double taxation of corporate dividends, so raising payouts is a simple way to return cash.

The Midstream Story over the past several years has largely been about financing growth projects. Investor payouts were sacrificed, but rarely did a company admit that its internal cost of capital was too high to justify a new initiative. Wells Fargo is challenging management teams to regard buying back their own stock as a more attractive use of capital than building or acquiring new assets. This is capital management 101 for most industries, but unfamiliar terrain for pipeline stocks. Growth is embedded in the culture. The original justification for the GP/MLP structure with IDRs was to incent management to grow the business. CEOs in other industries find the motivation without such complexity.

In October, virtually every 3Q18 earnings call included an optimistic outlook from management, usually coupled with disbelief at the continued undervaluation of their stock. Attractive valuations mean a high internal cost of capital. Valued by DCF, or Free Cash Flow (FCF) before growth capex, midstream yields are in some cases higher than many companies’ stated Return on Invested Capital (ROIC) targets. Moreover, historic ROIC for the industry has often turned out lower than promised, although it has been improving.

Energy Transfer’s (ET) 16% DCF yield almost certainly offers a higher return than all but their best projects, and suggests they should be repurchasing stock. SemGroup’s (SEMG) DCF is 20%, twice the industry’s historic ROIC.

Growth caused the past four  years’ upheaval, and today’s low valuations are the result. Capital discipline has been less present than CEOs often claim, which is why they’ve apparently responded coolly to Wells Fargo’s buyback recommendation.

DCF yields of 10-14%  or more (as with ET’s 16%) are dramatically higher than FCF yields of 3%, because DCF measures cash generated before funding for growth projects while FCF is after.  FCF yields are set to rise sharply over the next few years, but this crucially relies on new investment coming down. The industry has a habit of showing that peak spending on new projects is imminent, only to push that back another year. 3Q earnings calls saw 2019 estimated capex creep up by almost 20%.

Midstream Industry Forecasts Peak in CAPEX

2018 is the fourth year of distribution cuts for MLPs, as reflected in the Alerian MLP ETF (AMLP). Corporations have fared better, and next year we expect dividends on the American Energy Independence Index to grow by 8-9%. If midstream companies are as financially disciplined as they claim, they’ll follow the advice from Wells Fargo in evaluating stock buybacks alongside new investments under consideration. It would complete their metamorphosis into more conventional companies.


We are invested in ET and SEMG.

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 (