Incoming President Biden is expected to take the U.S. back into the Paris Climate Agreement, which will mean policies to reduce emissions of GHGs (Green House Gases) will figure in Administration policy.  

Polls showed that two thirds of registered U.S. voters described climate change as “somewhat” or “very” important in how they voted. As we saw last week, opinion polls were poor predictors of the election, Democrats received a substantially smaller share of the vote than this poll would have suggested.  

A survey last year found that 68% of Americans wouldn’t even pay $10 a month in higher utility bills to combat climate change. It seems fair to say that, beyond a small group of climate extremists, support for green policies doesn’t have widespread economic support. The Democrats’ weaker than expected electoral result reflects this.  

White House executive orders to combat climate change could even lead to a healthy debate about where emissions are growing and the cost of solutions. The two charts below are informative.  

The first is from a 2018 paper called “Measuring Renewable Energy As Baseload Power” published in 2018 by the University of North Carolina. Proponents of solar and wind power often superficially claim that renewables are now cheaper than natural gas power plants. A true comparison needs to account for their intermittency (it’s not always sunny and windy). So the authors walk through a cost comparison of a 650 Megawatt (MW) Natural Gas Combined Cycle (NGCC) power plant running 85% of the time with solar or wind on equivalent terms. The 85% uptime for an NGCC plant allows for maintenance approximately 55 days a year. Solar intermittency means it’s producing power only 21% of the time, peaking around noon.  

A correct comparison between the two requires combing the renewables power production with either (1) a smaller NGCC plant, or (2) battery storage. This raises the solar plus model to the 85% capacity utilization of the NGCC plant. 

The study compares the cost of an NGCC plant with four different combinations of solar and/or wind plus supplemental power.  

The point is that using renewables when they’re available can be cheap. But relying on them is not. California is finding that a purist approach to power generation of eliminating all fossil fuels plus nuclear is both more expensive and unreliable (see California Dreamin’ of Reliable Power). It’s not a combination many should find attractive.  

The second chart shows coal-burning power plants in the world’s top ten users. China, the world’s biggest emitter of GHGs, doesn’t just operate far more coal burning power plants than any other country. They’re also building almost as many new plants as the existing U.S. coal fleet. This issue receives very little media attention, although the FT did highlight it recently (see Climate change: China’s coal addiction clashes with Xi’s bold promise). This is why China is planning to increase its GHG emissions over the next decade.  

If the Administration pursues policies that impede the use of natural gas for power generation in favor of renewables, intermittency and China’s role in curbing emissions will receive more attention. It’s a debate worth having. 

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Pipeline companies have been reporting earnings. As has been the case recently, they’ve been generally coming in as expected, reflecting the stability in their underlying businesses. In many cases it’s hard to see much Covid impact at all. Williams Companies (WMB) reported 3Q adjusted EBITDA down 1% year-on-year.  Enterprise Products Partners (EPD) was similar.  

A bigger story has been the growing trend towards announcing buybacks. This is a visible confirmation of growing free cash flow (see Pipeline Cash Flows Will Still Double This Year, posted in May and remaining accurate ever since).  

EPD has had a buyback program in place for the past year. Kinder Morgan (KMI) and Energy Transfer (ET) have both said that buybacks are a possible way to return cash to shareholders in the future. More tangibly, MPLX announced a $1BN buyback last week. Targa Resources (TRGP) and Plains all American (PAGP) followed up with $500MM each. Enlink announced $100MM.  

It’s beginning to look like a trend.  

Midstream energy infrastructure has been weighed down by a steady stream of outflows from MLP-dedicated mutual funds and ETFs — around $6.5BN over the past year. With over $2BN in new buyback announcements just last week, this source of additional demand could well absorb future sales by funds. This would allow the increasingly positive cash flow story to unfold, lifting prices.  

An interesting perspective on the value of dividends was provided by Altus Midstream (ALTM). Operating with 5X Debt:EBITDA and questionable prospects in its natural gas gathering and processing business, it has been a target of short sellers for some time. Covid has reduced crude oil output in the Perman basin, thereby reducing the volume of associated natural gas which has allowed prices to rise.  

Higher prices are supporting volumes through ALTM’s gathering network, and next year Kinder Morgan’s new Permian Highway pipeline will improve producer economics by offering a new transportation option from the Waha hub to the Texas gulf coast.   

ALTM surprised the market by instituting a quarterly dividend of $1.50, starting next March. Forget the financial theory that dividends don’t matter – ALTM tripled in price on the announcement. Even after adjusting to the news, at $30 the stock will yield 20% when dividends start next year.  

With Republicans looking likely to retain control of the senate, pipeline investors can contemplate little prospect of any sweeping legislation that might harm the energy sector. But a President Biden is likely to use regulation and executive actions to further impede new construction. On Energy Transfer’s earnings call on Wednesday, executives commented that an extensive network already installed must have even more value when little new can be built. We discussed this and included clips from the earnings call on Friday’s podcast (listen to Energy Executives and the Election). We’ve dubbed it “Goldilocks Gridlock” from the perspective of the energy sector.  

We also provided a brief update of the post-election outlook in the SL Advisors Post-Election Energy Outlook webinar. 

Earnings, buybacks and divided government provided plenty of positive fundamental news for midstream energy infrastructure.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Energy Transfer’s (ET) 50% distribution cut announced late on Monday surprised most observers. Given the comfortable 1.4-1.5X DCF coverage this year and next, many felt that there was little pressure to reduce it. However, the persistently high yield (18% before the announcement), reflected widespread investor skepticism around its sustainability. Debt:EBITDA of 5X is higher than the prevailing 4-4.5X standard for investment grade names in the sector.  

The company’s press release provided no additional color, and the 3Q20 earnings call will be next Wednesday, when election results will dominate the news.  

Distribution cuts are rarely well received. Income-seeking investors who used to be the core investor base for pipelines have endured them for years. Few could be shocked by one more. The payout on the Alerian MLP ETF (AMLP) is 50% below its peak of February 2016. Since ET is a 10.1% position in its index, the Alerian MLP Infrastructure Index (AMZI), AMLP is likely to cut a little more. MLP-dedicated funds run by Invesco are also significant ET holders, highlighting the problems such funds face with a shrinking pool of investable names (see Why MLP Fund Investors Should Care When They Change).  

Selling on Tuesday following the announcement likely reflected disappointment from investors who had believed the DCF coverage meant it was secure.  

The problem was that too few investors believed the distribution would be maintained, and this became a self-fulfilling prophecy. The high yield meant it was a waste of money to keep paying it. The stock is too cheap to be used as an acquisition currency. Retiring CEO Kelcy Warren’s substantial income from the distribution was one of the arguments for its continuation, but he can probably get by on less.  

A few weeks ago we contrasted the negative view of ET held by equity investors with the relative equanimity shown by their bond yields (see The Divergent Views About Energy Transfer). As the chart shows, strong differences of opinion about ET persist across the capital markets. A ten year bond issued by ET in January last year trades above par, after falling sharply earlier this year. By contrast, ET’s stock price remains at just half the level it was when the bonds were issued.

This is a theme with investment grade pipeline stocks. Enterprise Products Partners (EPD) is another example of a company whose bonds reflect a much more positive outlook than does their stock (see Stocks Are Still A Better Bet Than Bonds).  

Pipeline stocks have long abandoned any connection with Miller-Modigliani and the Capital Asset Pricing Model (CAPM). Theoretically, investors should be indifferent to leverage or dividends for example, but in practice they are not. Once the reactive selling from those who liked the former 18% yield is finished, investors will see a company with more financial flexibility. They could use some of the cash freed up by the distribution cut to repay debt, although their bonds are expensive. Or they could initiate a stock buyback, directly confronting their low valuation.  

We’ll need to wait until next Wednesday to learn more. ET has often been criticized for exploiting its investors where possible. The convertible preferreds they issued to management in 2016 following the ill-fated pursuit of Williams Companies (WMB) permanently cost them trust in the marketplace, and is a reason for their continued depressed stock price (see Energy Transfer’s Weak Governance Costs Them). Newly promoted co-CEOs Mackie McCrea and Tom Long have an opportunity to demonstrate good faith with investors.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

MLPs have been losing relevance to the midstream energy infrastructure sector for years. The Shale Revolution caused them to evolve from reliable generators of income to growth-seeking enterprises. As upstream companies plowed money into drilling, pipeline companies felt compelled to add new infrastructure to service them. The capital spending spigot had already been ratcheted down since 2018, with investors rebelling against the culture of always building. The hit to demand from Covid accelerated a trend already in pace.  

MLPs represent around a third of the pipeline business. This has left MLP-dedicated funds increasingly challenged to find enough names to build out a portfolio. It’s a dilemma we’ve forecast for a long time (see The Uncertain Future of MLP-Dedicated Funds, April 2018). Such funds, most notably the Alerian MLP ETF (AMLP), were already burdened with an inefficient structure (see Uncle Sam Helps You Short AMLP, July 2018).  

The MainStay Cushing MLP Premier Fund (CSHAX) has decided to bite the bullet and abandon their anachronistic structure. In recent weeks they’ve been quietly informing clients that they plan to limit MLPs to 25%, because of the “significant contraction” of MLPs. It’s taken them longer than it should, but they’ve accepted that the MLP business has changed. Serial distribution cuts imposed on income seeking investors have lost those investors to the sector for good.  

CSHAX is around $500MM in AUM. Bringing their MLP holdings below 25% will require them to shed 75% of their portfolio, around $375MM, over period of months. MLP funds have seen around $6BN of outflows in the past year, and this has weighed on prices. Even so, the CSHAX repositioning should be manageable. 

But what if other MLP funds reach the same conclusion? The Invesco Steelpath family of MLP funds is over $3.5BN. Center Coast and Goldman each have another $800MM. And AMLP is $3.3BN. There’s over $13BN invested in flawed, MLP-dedicated funds.  

MainStay Cushing’s move is logical, but nobody will want to be the last one jumping. They’re not the first either. Some smaller closed end funds have combined and become RIC-compliant by limiting MLPs to 25%. The Kayne Anderson MLP/Midstream Investment Company recently became the Kayne Anderson Energy Infrastructure Fund (still KYN). Dropping MLPs is a developing trend. 

It should induce investors in all MLP-dedicated funds to ponder their fund’s future. If bigger funds follow MainStay Cushing, the MLP sector could find itself having to absorb an indigestible amount of sales. Alerian calculates the market cap of MLPs at $139BN, but it’s only $72BN when adjusted for float. For example, the Duncan family’s 32% ownership of Enterprise Products Partners (EPD) doesn’t provide any liquidity. The remaining MLP-dedicated funds are almost 20% of the market. 

MLPs are cheap by any reasonable measure. We’ve noted the yawning gap between EPD’s debt and equity yields (see Stocks Are Still A Better Bet Than Bonds). Bond and stock investors are poles apart in their assessment of the sector. But the risk investors in MLP-dedicated funds face is that portfolio shifts by competitor funds depress MLP prices, driving down their own fund’s NAV. 

The near–term future of MLP-dedicated funds is unclear. But the time for such vehicles has passed, and it seems inevitable that funds invested in midstream infrastructure will limit MLPs to 25%. You just don’t want to be in the last fund to decide to make the shift.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

In recent weeks, 2021 natural gas have been quietly moving higher. November ’21 futures have rallied over 40 cents, to just under $3 per Thousand Cubic Feet (MCF).

Covid and the election are both behind this. Research reports from Goldman Sachs and Morgan Stanley both explore energy markets through the pandemic and likely policy changes if Democrats win next month.

Associated gas that is produced along with crude oil in the Permian in west Texas has long weighed on prices. This gas wasn’t needed – because it had so little value, some of it was flared. The Texas Rail Road Commission (RRC) never rejected a flaring application, causing critics to ask why they regulated it at all (watch Stop Flaring).

The collapse in oil demand in the Spring led to production cutbacks in the Permian, which also reduced the volume of associated gas. Morgan Stanley notes that falling prices had already been reducing the gas rig count in key producing areas prior to Covid, and this trend accelerated during the spring. Domestic gas production is increasingly driven by the economics of the gas market.

The election has had a more recent impact. With Joe Biden retaining his lead in opinion polls, markets are beginning to price in a Democrat victory, including the possibility of taking control of the Senate. VP candidate Kamala Harris pledged that a Biden administration would not ban fracking – a predictable pivot away from the anti-fracking posture Biden adopted during the primary.

Some of the more sweeping moves against the domestic energy business associated with the Democrat platform would require acts of Congress. This includes banning fracking on private land. Another example would be tightening the standards around produced water, since the 2005 Energy Policy Act excluded fracking from the Safe Drinking Water Act. It’ll be hard persuading senators from either party in oil-producing states to support legislation that’s harmful to their voters.

However, Goldman notes that a Biden presidency could restrict drilling on Federal land, clamp down on methane emissions and use other regulatory tools to increase the cost of production. Democrat policies are designed to produce higher energy prices, since this improves the competitiveness of renewables (Listen to Joe Biden and Energy and read Why Exxon Mobil Investors Might Like Biden).

A new administration might also engage more with Iran. Goldman notes that the return of 1 million barrels per day or Iranian output to oil markets would restrain Permian crude production and keep a lid on associated gas. It’s not intuitive, but diplomatic engagement with Iran is bullish for natural gas prices.

Will this be good for pipeline stocks? Trump pursuit of energy-friendly policies has led the industry into an exuberant glut of production. It’s not his fault, but it’s led to poor investment returns. Rising natural gas prices could be a sign of more parsimonious capital allocation. If pipeline stocks follow energy prices up the same way they’ve followed them down, few investors will complain.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.