Targa Resources, a perennial mis-allocator of capital, is not an obvious candidate to initiate a buyback program. Nonetheless they did on Monday, and the stock rose almost 11% on the news. In February last year, when Joe Bob Perkins was CEO, he responded to questions about their capex plans by arrogantly calling them “capital blessings.” This reflected an attitude that building new infrastructure and buying assets was part of their mission, regardless of whether such projects made financial sense.

TRGP’s stock performance says much about how they have allocated capital in recent years. It’s lost almost two thirds of its value over the past year, and 88% from its all-time high in 2014 when Energy Transfer was believed to be interested in acquiring them. Perkins remains with the company as Executive Chairman, having undelivered and been overpaid.

If the buyback reflects a new respect for the math behind how the company deploys its cash, it represents an overdue shift. TRGP is on track to begin generating Free Cash Flow (FCF) next year. Although buybacks allow plenty of discretion around timing, the market welcomed the announcement that $500MM would be dedicated to repurchasing stock.

TRGP’s buyback program is roughly equal to their expected 2021 FCF, so they’re to complete the program quickly. But it’s worth noting that, if the industry similarly dedicated its 2021 FCF to buybacks, that would amount to $40BN in purchases, twice the size of all the mutual funds, closed end funds and ETFs in the sector. There’s much more FCF available than what’s at TRGP.

In another sign that the MLP structure retains few friends, TC Energy (TRP) announced they’d be buying in the rest of TC Pipelines (TCP) that they don’t already own. With a 9% yield and limited investor base, TCP isn’t much use as a source of capital. It’s down 23% over the past year, whereas TRP has dropped 15%. Without a ready pool of K-1 tolerant income-seeking buyers, TRP concluded there was little value in maintaining their MLP.

Both TRGP and TRP are buying their own securities, which they deem undervalued. This is positive news.  As more of the industry follows suit, it will provide further support for a beaten-down sector.

On a different topic, Jared Dillian wrote an informative article (see ESG Investing Looks Like Just Another Stock Bubble) highlighting how much of the interest in ESG investing is a fad. Picking companies that possess good ethical values seems pretty reasonable – except that the beauty of ESG lies in the beholder. Because there are no agreed criteria, just about every company can claim such credentials, and most do. For example, coal producer Peabody Energy publishes an ESG report.

Dillian notes that much of the returns to ESG investing have been driven by liquidity. Inflows have surged over the past year, with Morningstar estimating almost $200BN invested in ESG funds.

Given the numbers involved, few companies can risk being non-ESG. Pipeline corporations are included (watch ESG Investors Like Pipelines), as they should be since increased use of natural gas is replacing coal in power generation. This is the biggest driver of reduced emissions in the U.S.

Confusingly, this means that Williams Companies’ (WMB) ESG credentials are based on successfully reducing demand for Peabody’s product.

MLPs generally don’t show up in ESG lists, because their weak governance (the “G” in ESG) disqualifies them.

The infinite flexibility of ESG is shown by Lockheed Martin’s (LMT) regular inclusion in the Dow Jones Sustainability Index. Manufacturing products that blow people up sustainably meets the threshold. This is why Jared Dillian is right to say, “…ESG is nothing but a passing investment fad.”

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

With pipeline stocks having their worst month since the depths of Covid-panic selling in March, investors are wondering when the smart money will finally respond to today’s extreme undervaluation and commit capital. Recent price action makes little sense, something that becomes very apparent in discussions with clients. 2Q20 earnings were as expected, and dividends unchanged. The yield on the American Energy Independence Index, the most representative index of North American midstream energy infrastructure, is now over 10%.

Two items stand out as the most compelling bullish arguments. The first is that the yield on Free Cash Flow (FCF, the cash flow available after ALL capex spending) is approaching 13% for 2021. We had previously been targeting $30BN for next year, (see Pipeline Earnings Should Confirm Growing Cash Flows), but following second quarter earnings have revised this higher, to $40BN. We don’t know of another sector of the market delivering such a high FCF yield. The broader market’s FCF yield is around 4% and the utility sector, the one most similar to pipelines, has a negative yield.

The jump in FCF is driven by continued falling growth capex, which peaked in 2018. Pipeline companies are reinvesting less in the business, leaving more for buybacks, deleveraging and distribution increases. Pipeline companies are still investing in growth though, spending on average 6% of their market caps on growth capex.  A sustainable cash flow yield assuming no new projects approaches 20%.

The second bullish item lies in the gulf between perceptions of bond and equity investors in the same company. Enterprise Products Partners (EPD) has 30 year bonds outstanding that yield 3%, less than a third of the distribution yield on their common units (see 4^th chart in Stocks Are Still A Better Bet Than Bonds). Energy Transfer issued 10 year debt early last year, which trades above par following a sharp dip in March. Meanwhile, its common units have sunk to less than half the price at which they traded when the debt was issued (see The Divergent Views About Energy Transfer). While the dour view of equity markets towards the energy sector has driven prices down to where payouts yield 10% or more, long term bond investors see little to concern them. Conventional wisdom holds that bond investors are usually right, because they do more detailed analysis. But that is little comfort for today’s pipeline investors.

Berkshire Hathaway’s $10BN purchase of Dominion Energy’s natural gas pipeline network last month was welcomed by some investors as confirmation of the inherent value in the sector. The natural gas outlook offers more clarity than for crude oil. Covid dramatically altered travel. Gasoline consumption in the U.S. has recovered to within 10% of year-ago levels, but it’s widely believed that office work will never be the same. Increased remote working, less use of public transport, and migration to the suburbs complicate long term forecasts.

By contrast, since natural gas has minimal use in transportation, it is shielded from this uncertainty. Domestic consumption is down slightly from a year ago, but exports are rising and growing demand from developing countries is forecast in the years ahead. Moreover, continued phasing out of coal plants and increased use of renewables are likely to require more natural gas, both here and abroad.

Although California aims to rely on solar and wind for almost all their electricity, recent power outages and high prices make this a strategy few will care to follow. It’s unlikely intermittent renewables can maintain their growth without further reliance on always-there natural gas power plants.

For the twelve months ending in June, natural gas generated 1.6 Terawatt Hours (TW) of electricity. This was an increase of 124 Gigawatt Hours (GWh), or 8%, compared with the same period a year ago. To put this in perspective, total solar power generation over the past year was 81 GWh. On a percentage basis, renewables show high growth, but in absolute numbers natural gas growth dominates. Solar and wind growth combined was 58 GWh, less than half the growth in natural gas. As we switch off coal burning power plants, they are more often replaced with natural gas.

Meanwhile, Berkshire Hathaway has quietly become the sixth biggest operator of natural gas pipelines in America. Buffett presumably sees many years of predictable cashflows from these assets, offered at a cheap price. The smart money is here.

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

The contrast between the pricing of debt and equity issued by pipeline companies is probably the topic that most engages clients in our discussions. In a recent piece on the equity risk premium (see Stocks Are Still A Better Bet Than Bonds) we used the example of Enterprise Products Partners (EPD). Because EPD’s common units yield 3X its long term debt, an investor with the flexibility to move from one asset class to another could achieve a bond-like return by investing a small portion of her capital in the equity.

In short, it seems implausible for the market to be so enthusiastic about a company’s long term debt while at the same time pricing its equity as if prospects are dire. Nonetheless, this fairly describes the current state of the public markets for midstream energy infrastructure securities.

Bond yields are low everywhere, partly the result of inflexible investment mandates by a significant portion of the global investor base. We have touched on this issue before (see Blinded By The Bonds and Real Returns On Bonds Are Gone). The persistence of negative real yields on sovereign debt, and indeed negative nominal yields, such as German ten year government bonds at -0.50%, can hardly reflect a widespread fear of deflation. Fiscal discipline is no contest for fighting the pandemic, and the Federal Reserve has even modified its inflation targeting to allow an overshoot of 2%. The only logical conclusion is that a great many institutional investors own bonds not because they want to – but because they have to.

This situation has been years in the making. Rates fell to previously inconceivable levels during the 2009 financial crisis, and have remained there ever since.

The comparison of Energy Transfer (ET) debt and equity over the past eighteen months offers a striking example of investors’ divergent views.

ET issued new ten year bonds in early January 2019, with a yield of 5.25%. The chart above shows the path followed by this debt and ET’s common units from that issue date. The two securities tracked one another for a few months before the bonds began to modestly outperform.

During the pandemic, debt and equity both fell sharply. The bonds fell less, reflecting their senior position in the capital structure. But the most striking feature of the chart is that the bonds have almost completely recovered and trade well above par, while the equity remains 50% lower than January 2019.

ET has a poor reputation for corporate governance, something we have noted (see Will Energy Transfer Act with Integrity?). Kelcy Warren’s bare-knuckle approach to business has made many enemies. But the company didn’t suddenly adopt its culture.

Legal challenges with the Dakota Access Pipeline (DAPL) are a potential headwind, but DAPL is around 3.5% of ET’s EBITDA so even a complete shutdown shouldn’t seriously impact the company (see Pipeline Opponents Help Free Cash Flow).

If the company’s prospects are as poor as implied by the weakness in its equity price, its debt has no business trading with a 4% yield. Conversely, if its balance sheet is as solid as this yield implies, the equity is mispriced.

Just as bond investors seem to buy yield-less government bonds without regard to value, equity investors in this sector seem to sell with equal disregard for the outlook. MLP funds have labored under outflows virtually all year. In conversations with investors, the biggest source of frustration is that prices don’t reflect fundamentals, and are often under pressure. The consequent fund outflows are, for now, drawing more selling. Nobody worries about pipeline stocks being overpriced (a preposterous notion). They do ask when the stocks will go up.

The answer is, when the current cohort of frustrated sellers is done. It could be any day.

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

Long-time MLP investors need little reminding that the sector is out of favor. The Alerian MLP ETF (AMLP), with its tax-inefficient structure (see MLP Funds Made for Uncle Sam) has been shedding clients for years (see AMLP’s Shrinking Investor Base). Its focus on MLPs while they dwindle in number means it omits most of the biggest pipeline companies, as they’re corporations. AMLP’s distributions are down by a third (see Why Are MLP Payouts So Confusing?).

AMLP is designed to provide passive exposure to the Alerian MLP Infrastructure Index (AMZIX). It turns out that pipeline companies haven’t done nearly as badly as this index. The focus on MLPs has always excluded corporations – for many years, when MLPs were controlled by a General Partner (GP), Incentive Distribution Rights (IDR) allowed generous payments from the limited partners in AMZIX to the GP’s. Because AMZIX excluded corporations, it left out many of the GPs who were receiving IDRs payments. Although this model has largely disappeared, the exclusion of most GPs meant that AMZIX included the inferior side of the GP-LP equation. And there remain a handful of MLPs that still labor under the burden of making IDR payments to their GP — all unfortunately included in AMZIX. These include MLPs Cheniere Energy Partners (CQP, controlled by Cheinere Energy Corp, LNG) and TC Pipelines (TCP, controlled by TC Energy, TRP). Avoiding MLPs that owe IDR payments to a parent would have helped AMZIX perform better.

The GP-LP relationship has always looked more like the one between a hedge fund manager and its hedge fund. Hedge fund managers and MLP GPs both fared much better than investors in MLPs and hedge fund (see MLPs and Hedge Funds Are More Alike Than You Think).

Canadian pipeline companies are among the best run in North America. In recent years they have been acquiring MLPs, rolling them up into the corporate parent. For example, Enbridge acquired U.S. pipeline company Spectra Energy, which included Spectra Energy Partners, its MLP, in 2016. Transcanada (TRP) bought Columbia Pipeline Group the same year, and later rolled up their MLP. All these acquisitions led to the assets leaving AMZIX, because they were no longer housed in MLPs. Excluded from AMZIX but still significant was when Pembina (PBA) bought Veresen in 2017 and also acquired Kinder Morgan Canada after it has sold its Trans Mountain Express pipeline expansion to the Canadian Federal government.

In early 2018, the Federal Energy Regulatory Commission (FERC) surprised investors with a tax ruling that prevented MLPs from including investors’ imputed tax liability in setting natural gas pipeline tariffs. Although FERC later walked back this hasty ruling, the damage was done and natural gas pipelines are largely housed in corporations, where FERC’s tax ruling has no effect.

The general shift from MLPs to corporations as the desired corporate form, so as to access a broader set of investors, has taken place throughout this time. The result is that AMZIX doesn’t reflect the North American pipeline industry (see MLPs No Longer Represent Pipelines). It has the last three big pipeline companies that maintain their MLP status, and a bunch of small gathering and processing names that are more risky. It also has an overweight to crude oil and refined products pipelines, with a corresponding underweight to natural gas pipelines.

AMZIX has wound up with a form of adverse selection – seemingly always on the wrong side of the trade. Holding MLPs that paid IDRs to GPs, rather than GPs themselves; gradually becoming more concentrated as MLPs were rolled up into corporations; and drifting away from natural gas pipelines, leaving them with commensurately more crude oil risk at a time when transportation demand faces a lot of uncertainty.

The American Energy Independence Index (AEITR) was always designed to reflect the better side of the historic GP-LP relationship, and to be broadly representative of the North American pipeline industry. MLPs, as defined by AMZIX and its associated investment product AMLP, have had a miserable decade. But the broad North American pipeline industry as defined by AEITR has done substantially better over multiple timeframes, because of the construction advantages noted above. For almost the past decade it’s performed 14% p.a. better

When an investor complains about lousy MLP performance, they’re right, but they’re also revealing that they’ve had too much exposure to the wrong index.

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

Californians have recently been enduring rotating blackouts – short term loss of power due to excessive demand. When the lights go out and the a/c units no longer hum, it’s always political. Oddly, both sides can agree that climate change is to blame. Liberals attribute the extended high temperatures in southern California to the gradual manmade warming that is afflicting the planet. Conservatives see a reliance on unreliable renewables as the cause – underlying the power supply shortfall was the loss of 100MW of output from a wind farm.

Perhaps global warming is making it less windy. Environmental extremists will argue that fighting climate change is ever more urgent, while pragmatists will note that using more intermittent renewables is leaving consumers vulnerable to shortages.

What’s happening in California is important to all Americans, because it’s a preview of what an energy policy run by environmental extremists could look like if inflicted across the entire country.

For the past decade, California has been steadily pushing renewables’ share of power generation. For much of that time natural gas was easily the biggest source of electricity, since coal use stopped completely in 2015.

But environmental extremists have been single-minded in their desire to run everything with solar panels and windmills. Although the state has not banned natural gas, it does allow cities and counties within the state to do so. Diablo Canyon, California’s last remaining nuclear power plant, will close its two reactors in 2024-25.

In 2018, California passed a law mandating 50% of its electricity to be from renewable sources by 2025, 60% by 2030 and 100% by 2045. There are no plans to build new nuclear capacity, so it looks like sun and wind will be the major source of power.

America has been reducing its CO2 emissions, but oddly California has been lagging the rest of the country, with a slight worsening since 2011. This fact must sit uncomfortably with those thoughtful advocates of California as a leader in renewables. The problem, as anyone trying to drive around Los Angeles knows, is that transportation still relies heavily on fossil fuels. A couple of years ago when I was visiting clients with a salesperson for a couple of days, traffic estimates were critical to our meeting schedule. In fact, every meeting seemed to open with a brief chat about the 405. Automobiles and traffic jams generate a lot of California’s emissions.

California’s renewables effort has focused on electricity, but that’s less than 14% of total energy consumption. This is why the popular image of green California isn’t reflected in reduced emissions.

The average retail price of electricity in California is 16.58 cents, versus 10.53 cents for the country as a whole. Unreliable power that costs 57% more than the average, along with a slower rate of emissions reduction, are not the hallmarks of a successful policy to combat climate change. This is where the drivers of Joe Biden’s energy policy are hoping to take us. The Biden-Sanders Unity Task Force has recommended, “…eliminating carbon pollution from power plants by 2035”. This is a decade ahead of California – because it’s going so well there.

California’s power blackouts are in part because the wind has inconveniently not been blowing when needed. This is why natural gas is such a good compliment to intermittent renewables – it’s always available. Many other U.S. states have embraced this, including Nextera (NEE), loved by environmentalists and investing in natural gas pipelines.

Energy density is another challenge that will lead to NIMBY problems.

An article in the Financial Times (see Green power needs to be dense power) compared the 950 acres required for a UK solar farm to produce 350 megawatts of power with the 80 acres to house a nuclear project with 3,200MW of output. Not only is this 9X the power output on under 9% of the land, but the solar plant is only expected to operate at 11% capacity, versus 90% for the nuclear. The power output per acre is 1,000 times lower for this solar installation compared with nuclear, a significant problem in densely populated Britain.

Any solar installation in the UK is a green extremist triumph in willful denial of the climate – but at least they’re still building nuclear plants, because they do want to keep the lights on.

California’s blackouts show what happens when climate extremists run energy policy. The silver lining for investors is that such policies lead to, and desire, high energy prices – both as a constraint on demand and also because it makes renewables less uncompetitive. Returns on energy investments tend to follow energy prices. Green policies that constrain supply need not be bad for the sector.

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