An Apocalyptic Fund Story

The Four Horsemen of the Apocalypse, as far as long term investment returns are concerned, are excessive fees, leverage, taxes and over-trading. Any one of these can be relied upon to eat into the results sought by the long term investor. Add an excess of all four and you wind up with a toxic brew that impedes reaching your investment goals and can seriously impair your capital. We recently came across a security which incorporates all of them, and it provides a startling reminder of just how relentlessly capital can be destroyed when these four villains are able to work in concert together. As you’ll see, they have wrought an investment disaster of biblical proportions.

The Cushing MLP Total Return Fund (SRV) stands as a testament to much that is wrong with some of the investment products on offer. Although I often write about Master Limited Partnerships (MLPs), this fund’s focus on our favorite asset class is incidental to the story. The lessons herein apply to any investment.

To begin with, SRV is a closed end fund (CEF). This is an intriguing backwater in which we once dabbled before concluding that there wasn’t enough liquidity to justify the time. CEFs are like mutual funds except that their share count is fixed; consequently, price and Net Asset Value (NAV) can and invariably do deviate from one another. One of the enduring mysteries of the CEF business is why anybody buys Initial Public Offerings (IPOs). With admittedly unfortunate timing, on August 27, 2007 Morgan Stanley led an underwriting of 8.75 million shares of SRV at $20, of which $0.94 went in underwriting fees. So investors were immediately down 4.7% on their investment, and could have chosen to avoid the excitement of the IPO and buy SRV the following day (presumably 4.7% cheaper if it traded at NAV). After all, this was not Google, but simply a fund holding other publicly listed securities. But the machine worked, as it usually does, and investors were duly parted from a modest portion of their funds in exchange for misplaced hope.

SRV is organized as a corporation rather than as a Registered Investment Company (“RIC”), and I’ll spare readers detail of the consequences other than to note that SRV expected to pay 35% of its returns to the U.S. Treasury as corporate income tax (since it is a corporation). SRV planned to use up to 40% leverage, relying on the leverage-magnified returns to cover most of the tax. This only really works when a security such as SRV only goes up, but to point out this possible flaw seems small-minded in the face of such boldness.

The 2008 financial crisis was just months away. The demise of Bear Stearns, collapse of Lehman and government bailout of AIG led many to pray for investment relief. They were dark days indeed. For comparison, we are going to consider SRV’s returns against two other indices; the Alerian Total Return Index (AMZX), and a customized index reflecting SRV’s structure, which uses AMZX with 40% leverage, a 35% tax rate, and 5% expenses (all assumptions lifted from the 2007 prospectus). We’ll call this the Alerian Stupid (AMZS) in honor of the hapless souls who aspired to its results.

In spite of the storm clouds in 2007, the AMZX returned 3.3% for the remainder of the year following SRV’s IPO, and even the AMZS was +1.7%. However, SRV left its initial investors smarting with a -14.4% reduction in the value of their investment. Worse was to come, and markets plunged in 2008 with AMZX delivering         -36.9%. AMZS was only slightly worse, at -37.4%. While leverage amplified the losses, the tax burden is assumed to work as a benefit in a down market rather like a net operating loss (those interested in more detail can find it on our blog under The Sky High Expenses of MLP Funds). SRV quickly parted company with these indices, and turned in an eye-popping -69.3%. CEF experts may note that many closed end funds moved to a substantial discount to NAV in 2008 which exacerbated the fall in price many suffered. However, Morningstar  shows that SRV remained at a premium to NAV fNewsletter August 2015 Chartor most of the year and indeed throughout its life until the end of last year. CEFs usually trade at a discount to NAV and many individual investors trade them seeking to exploit this fact. The consistent premium at which SRV has traded reflects optimism by investors tragically not repaid by results.

In 2009 markets roared back, and SRV delivered an astonishing +118.6%, well ahead of AMZX at +76.4% and AMZS at +60.2% (taxes really hurt that year). Emboldened by this performance, SRV investors drove the premium to NAV up during the year and by early 2010 it reached 40%, an apogee of irrational exuberance that causes wistful nostalgia in today’s investors. At this point Cushing, aided by a different set of underwriters, sensibly exploited the premium by announcing a secondary offering of 6 million shares priced at $10, half the level of the IPO. A 2011 supplement to the 2010 prospectus also revealed portfolio turnover of 301% in 2010 and 526% in 2009 (high turnover is our fourth horseman). Holders of SRV may have thought they were investors, whereas the data suggests a manager frantically trading with little evidence of any thoughtful strategy.

The years since have not been kind to the faithful (and their composition has changed via trading in the secondary market). Inconveniently, SRV has not risen consistently in price so as to most effectively avail itself of the benefits of leverage. The annual return from inception to June 2015 is -10.2%, compared with +4.6% for AMZS and 10.7% for AMZX. It shows the enormous difference between selecting the right asset class (since MLPs have done very well) and the wrong instrument.

The result is that today SRV languishes at $3.45, a country mile from its IPO price and at a discount of over 20% to its NAV. In 2015 MLPs have of course been weak, but the discount suggests that the level of enthusiasm for the stewardship of this fund has finally conceded to the reality of truly awful performance. The financial equivalent of Conquest, War, Famine and Death symbolized by the Four Horsemen have surely been visited upon the holders of this fund. Defenders might find fault with picking on an investment launched back in 2007, at a time when perhaps underwriting standards were lower. They might care to consider the Cushing Royalty & Income Fund (SRF), launched in 2012 and having lost 77% for investors since then for a -34% annual return. Obviously they have found a formula that works, after a fashion.

I have heard reports that a new portfolio strategy has been put in place for SRV and that prospects are better than in a long while for those investors willing to cast the past aside. There will probably be some – for although underwriters deserve blame for bringing poor products to market, self-destructive behavior by investors is also necessary to produce stories such as this one. The right thing for Cushing to do is liquidate the portfolio and buy back shares, thus ending a sorry chapter for an MLP manager that has produced ample wealth for its founders if not always for its investors. At least the remaining faithful would profit from the closing of the NAV discount. However, closed end funds represent permanent capital, in that they generate fees in perpetuity for the manager, and winding the fund up is never going to be as appealing to a commercially-driven operator as trying again with a new set of investors.

Even with the benefit of hindsight, it’s hard to fathom just how the underwriters and manager of SRV ever expected to generate acceptable returns. The tax drag, leverage, fees and subsequent turnover represented a formidable headwind, as shown by the difference between AMZX and our customized index, AMZS. Although SRV appeared just prior to a tumultuous time, overall asset class returns during its life have been good; better, perhaps, than those involved in its creation might have hoped in 2007. It was a structurally flawed security, and its existence reflects poorly on all the firms who have been associated with it. I recently chatted with a friend who was considering entering investment management but worried that he did not possess a sustainable investing edge. His caution was reasonable given his desire to offer a value-added service. However, as I pointed out to him, in some places the bar is set pretty low.

MLP Earnings Provide Update on Fundamentals

Energy investors have seen their holdings buffeted of late by the price of oil, and Master Limited Partnerships (MLPs) have been no exception to this. Their prices have moved as if they have substantial exposure to oil, whereas midstream MLPs are most notable for their cashflows being predominantly fee-driven. Over the past few days several firms reported quarterly earnings, showing business operations that are far less exciting than their security prices suggest.

Before we get to that, it’s worth contrasting recent news on planned capital investment from Royal Dutch Shell (RDS) with plans at Kinder Morgan (KMI). RDS announced they were cutting 6,500 jobs (out of a total workforce of 94,000) and reducing their planned capital spending by $7BN (to $30BN) as a result of weak oil prices which they expect to persist. There is a substantial timelag between shifts in the price of oil and changes in supply, but here’s one example of a reduction in future supply in response to lower prices. Kinder Morgan (as we noted in a previous blog post Kinder Morgan Isn’t Greek) recently increased its backlog of projects from $18.3BN to $22BN during the most recent quarter (these cover several years so longer than the one year over which RDS cut its planned investments). Both companies are in the Energy sector, and yet they’re experiencing the fluctuations in oil prices very differently.

To return to recent earnings, results from the companies we care about were generally good. Williams Companies (WMB) affirmed its 10-15% dividend growth through 2020 and currently yields 4.8%. Enterprise Products Partners (EPD) raised its distribution by 6% year-on-year and yields 5.25% with very conservative 1.3X coverage. Western Gas Equity Partners (WGP), the General Partner for Western Gas, LP (WES), increased its distribution by 34% year-on-year and reaffirmed its outlook for 30% growth going forward. It yields 2.5%. Finally, U.S. Silica (SLCA), whose main business provides sand to companies for use in fracking, saw its revenues fall 28% and sand volumes drop 13%, less than expected, resulting in a 15% jump in its stock price on the day of the release (although admittedly it remains lower than we originally expected.

In short, fundamentals on individual names are showing that the energy infrastructure business remains sound in spite of the weakness in their stock prices. Everybody would like to know when prices will rise; while we can note several solid earnings reports and can opine on business conditions, calling equity markets is hard. But the news we received over this past week was positive.


The Sky High Expenses of MLP Funds

If the arcane tax accounting of the mutual funds and ETFs that invest in Master Limited Partnerships (MLPs) is of no interest to you, let me save you some time and advise you to skip reading.

As the rest of you who have proceeded past the warning probably know, the attractive tax-deferred yields offered by MLPs require the investor to receive K-1s rather than 1099s at tax time. Many investors want to invest in MLPs without K-1s, and consequently funds were launched that provided a solution, of sorts. ’40 Act funds can hold MLPs on behalf of their investors and provide 1099s, but they may have to pay corporate tax on the returns. If the fund is RIC-compliant, in that it owns less than 25% publicly traded partnerships (i.e. MLPs), investors get pass-through tax status. However, if the fund is not RIC-compliant it is structured as a C-corp and subject to corporate taxes. So the result is that the investors in non-RIC compliant funds only receive 65% of the return (i.e. 1 minus the 35% corporate tax rate). The Mainstay Cushing Fund (CSHAX) is an example, but there are others. Unfortunately, $52BN of the $64BN invested in MLP investments via ’40 Act funds are structured as C-corps (Source: Alerian). Ron Rowland wrote about this issue as long ago as 2010.

The tax drag shows up as part of the expense ratio, so CSHAX sports an eye-popping 9.42% expense for the year through 2/27/15, of which 7.49%-7.94% is taxes. Other funds are similar. Remarkably, few investors are aware of the tax drag in the MLP investment funds they own. Not surprisingly, it’s hard to get anywhere close to the benchmark Alerian Index under such circumstances, since such funds solve the K-1 problem by throwing substantial amounts of their investors’ money at it — or more accurately, to the U.S. Treasury.

There is an odd sort of silver lining to this tax drag though; it works in both directions. Just as the fund delivers 65% of the upside, it also delivers 65% of the downside. As MLP investors are painfully aware, prices have been in retreat since last August, and in recent weeks retreat has become rout. Since the tax bill comes from unrealized gains, a reduction in those gains through a drop in market prices reduces the future tax bite commensurately. It results in lower volatility, which is normally a desirable quality for investors although in this case of dubious value; volatility could be further reduced if the corporate tax rate was increased beyond 35%, which is clearly not the type of risk management investors want.

There is an interesting and so far unanswered dilemma that can face such a taxable MLP investment product during an extended market turndown (perhaps such as the one we’re enduring). Just as the Deferred Tax Liability for unrealized gains can fluctuate with market moves, it can in theory become a Deferred Tax Asset (DTA). This can come about when the non-RIC compliant investment fund holds investments that are at a mark-to-market loss, such that rather than creating a future tax burden they represent something similar to a tax-loss carryforward, or a net operating loss. CSHAX among others seems to contemplate holding a DTA where market moves create one, according to its prospectus. This has the effect of increasing the fund’s NAV above what it would be simply based on the securities it holds. However, the accounting can quickly get tricky if investors begin to exit the fund. This is because an exiting C-corp ’40 Act investor that receives an NAV on their shares subsidized by the DTA leaves behind a fund that is now slightly smaller but has the same DTA, meaning the DTA represents a larger share of the remaining investors’ NAV. Continuing redemptions could propel this process to where benefiting from the DTA was no longer plausible, at which point the DTA could be subject to a “valuation allowance” (the language in the CSHAX prospectus). At that point, the fund might be in the unenviable position of providing investors still only 65% of the market upside combined with 100% of the downside, a set of circumstances likely to induce further redemptions, exacerbating the situation. As the funds themselves point out, the appropriate tax treatment is not clear. It’s an untested area.

This is theoretical. We haven’t actually seen this play out yet, but it’s a useful scenario to consider for such investors.

What should you do? If you own an MLP mutual fund or ETF, look carefully at the expense ratio. Funds set up as C-corps (i.e. not RIC-compliant) are an expensive way to access the asset class, and are unlikely to offer satisfactory returns. The best course is to sell and consider replacing with a RIC-compliant fund. At least the harm of the original investment error has been mitigated by the recent sell-off, since the tax treatment has cushioned the losses you’ve incurred. And if the Deferred Tax Liability of your MLP investment fund is heading in the direction of becoming a Deferred Tax Asset, with its uncertain ultimate realization to the fund, consider a more speedy exit.

How ironic that investors seeking to avoid the tax complexity of K-1s are nonetheless facing tax complexity of a different sort.

We also run a RIC-compliant mutual fund, and you can learn more about it here.

Nothing in this blog should be construed as offering tax advice.  Investors should seek their own tax adviser or tax attorney.  This document is not an offer to purchase or sell, nor a solicitation of an offer to purchase or sell an interest in a Fund.




MLPs Will Fluctuate

MLPs continue to be weak. Through yesterday the Alerian Index is -15.1% YTD and has now fallen 26.6% from the peak last August. This trend has accelerated in recent weeks. Since we are only now heading into earnings season for many names, the moves of late have been driven largely by macro issues. The drop in oil is the obvious culprit, but fear of rising rates and volatility in Chinese stocks are also playing a part in investor psychology. The Energy Sector broadly is also weak, with the Energy SPDR ETF (XLE) down -8.4% YTD.

Fundamentals for MLPs, and the actions of the people who run them, are mostly at odds with market moves. Kinder Morgan (KMI) reported quarterly earnings as I noted on my blog last week (Kinder Morgan Isn’t Greek) and the earnings call wasn’t substantially different from one or two quarters previously. The company continues to be on track for a $2 dividend this year (which gives it a current yield of 5.58%), continues to guide for 10% annual dividend growth through 2020 and has a $22BN backlog of projects. M&A activity such as Energy Transfer Equity’s (ETE) bid for Williams Companies (WMB) and Marathon’s acquisition of MarkWest (MWE) reflect the conclusion of industry insiders that the outlook justifies substantial commitments of capital at current valuations. Furthermore, insiders such as ETE’s CEO Kelcy Warren and KMI’s Chairman Rich Kinder recently made further personal investments in their stock.

The Alerian Index yields over 6.5% and even 4-5% annual distribution growth would provide a 10-11% overall return, something with which few if any other public asset classes can compete. Moreover, the focus on MLP GPs that we have holds out the potential for substantially faster growth.

Consequently, although the Alerian Index is -15.1% this year as noted, investing in MLP General Partners has provided substantial downside protection since our MLP SMA Strategy is down around -5.5% through yesterday for 2015 (past performance is not indicative of future returns). I’ve been invested personally in MLPs for many years, and even if I had correctly forecast the 26% drop we’ve seen since last August and acted on it by liquidating my entire MLP portfolio so as to reinvest at today’s prices, such a move would even now have been unprofitable. This is because I would have realized substantial gains earned over many years, thereby incurring a large tax bill.  In addition, our holdings have fallen far less than the Alerian Index as noted.

We use no leverage, and midstream infrastructure businesses such as the investments we hold have strong balance sheets. Prices will fluctuate, but there is a very low probability of any permanent loss of capital. Although I don’t personally recommend investing by looking at charts, visually the recent selling has gathered momentum and I’d suggest that recent sellers following almost a year of weakening prices are unlikely to include the most astute investors. We believe valuations are attractive and that long term investors should consider committing funds as appropriate to their individual situation.

I write a weekly blog as well as a monthly newsletter, so our current views are never far away. If you have any additional questions feel free to contact me.

We are invested in KMI, MWE, ETE, WMB.

We also run a mutual fund, and you can learn more about it here.

Kinder Morgan Isn't Greek

Over the past week we’ve witnessed a negotiation of monumental incompetence. Greece’s Prime Minister Alexis Tsipras successfully won a referendum rejecting bailout terms that were no longer on offer, presided over the subsequent freezing up of the economy as the banks were forced to close and finally agreed to worse terms than he and Greek voters had only just rejected. In most countries Tsipras would have been thrown out of office; in some he would have been overthrown by the military and imprisoned or worse. In Greece, the poor population is so punch-drunk from their economic depression they can barely grasp how poorly they’ve been led. It’s provided somewhat macabre viewing as the current crisis is resolved while setting the stage for the next one. As much as we may criticize our own elected leaders, the depths of governmental ineptitude can extend farther than most of us imagined elsewhere.

Greece has been a factor affecting financial markets of late, as have the negotiations with Iran over its nuclear program and the popping of the Chinese equity market bubble. It has most certainly been a period of macro concerns, with little fundamental news until recently to aid investors. Greece has been resolved as far as its ability to cause a financial shock; the deal with Iran looks as if it will lead to more oil supply while hopefully making the world marginally safer. Chinese equities continue to gyrate unpredictably. So it is that with two of these three concerns resolved for now in their market impact, investors can turn to corporate earnings to obtain a bottom-up view of their investments, having seen them buffeted of late by top-down developments.

Kinder Morgan (KMI) released their 2Q15 earnings on Wednesday. If you look through one of their investor presentations from six months ago, there’s not much difference between what they were saying in January and what they said on their earnings call. Earlier this year they projected dividends of $2 for 2015, and last week announced a 2Q15 quarterly dividend of $0.49, on track for $2. The company continues to target 10% annual dividend growth through 2020 which, when you stop to consider for a moment, is an uncommonly long forecast period that few companies match. Their backlog of projects also grew from $18.3BN in the prior quarter to $22.0BN, led by a $3.3BN planned investment in the North East Direct project (NED).

NED will eventually reduce the pipeline congestion that restricts the flow of natural gas to New England in the winter, something we wrote about in February (see Why Boston Pays High Prices For Electricity), thereby making greater use of domestic output in the Marcellus and Utica shale. Events in Greece, Iran and China don’t have much bearing on this project, but it’s investments like this one and many others that are expected to provide the growth in earnings to support KMI’s projected 10% dividend growth.

At its current stock price of $36.89, its $2 projected 2015 dividend yields 5.4%. It’s rarely wise to assume that sellers are anything other than intelligent, and certainly those who sold KMI at the time of their last earnings release in April when the stock was above $43 made a good trade, benefiting from the macro events cited above. Other macro factors may continue to dominate in the weeks ahead, but a 5.4% yield with 10% growth looks better than most investment opportunities out there.

We are long KMI.

Energy Transfer's Kelcy Warren Thinks Like a Hedge Fund Manager

Last Monday, June 22nd, Energy Transfer Equity (ETE) went public with their rejected merger proposal to Williams Companies (WMB) in an effort to force WMB to the negotiating table. WMB’s stock rose by most of the 32% premium ETE has offered, and in recent days has held on to most of that gain as the market has assessed likely outcomes. ETE’s presentation highlights the synergies of such a combination. Another comforting fact is the ownership of WMB stock by hedge funds Corvex and Soroban, who hold 5.6% and 2.8% respectively. Corvex has not always been a positive influence for stockholders, and last year we wrote about the “Corvex Discount” that should apply to any stock they own (see Williams Companies Has a Corvex Discount). However, in spite of this we are long-time investors in WMB. It’s worth noting that Corvex and Soroban are on WMB’s board, so their views will be a factor in any decision.

The headlines will focus on developments at WMB as they consider their strategic options in light of ETE’s interest in them. We think WMB is likely to move higher as a result. What’s drawn less attention is the likely outcome for Williams Partners (WPZ), the MLP that WMB controls as its GP. On May 13th, WMB announced plans to acquire the outstanding units of WPZ, in a transaction intended to boost WMB’s dividend growth in part through tax gains from depreciating the newly acquired assets from a higher valuation. It’s the same technique used by Kinder Morgan last year to fuel faster distribution growth at KMI when they announced plans to combine Kinder Morgan Partners, El Paso and Kinder Morgan Management into one entity (see The Tax Story Behind Kinder Morgan’s Big Transaction). The tax insight KMI had was that acquiring assets from a limited partnership allows them to be revalued at the purchase price, and thereafter depreciated against taxes from this higher level. The practical consequences were $20 billion in tax savings for KMI which helped fuel a doubling of their forecast dividend growth to 10%, and an unexpected tax bill for Kinder Morgan Partners unitholders since the transaction resulted in a sale of their LP units not necessarily at a time of their choosing.

WMB’s previously announced plan to acquire outstanding WPZ units is also driven in part by this favorable tax treatment. However, ETE’s merger proposal is conditional on WMB dropping its announced plans to buy WPZ. ETE doesn’t want that transaction to go through. As a result, although WMB’s stock rose substantially following the announcement, the price of WPZ units fell.

To understand why, you have to regard MLPs as hedge funds and MLP GPs as hedge fund managers, a view we’ve long articulated and one evidently shared with the senior managers of many MLPs (see Follow the MLP Money). If you want to control the assets of a hedge fund, you do that by controlling the hedge fund manager, not by investing in the hedge fund. Similarly, Kelcy Warren (ETE’s CEO) understands that to control the assets owned by WPZ he need only control WMB’s GP, not WPZ itself. Under this analysis, paying a premium to acquire WPZ units may not be the best use of capital, and in fact leaving WPZ as a publicly traded MLP (albeit with two thirds of its LP units owned by WMB) provides optionality. If WPZ’s cost of capital falls, ETE may drop assets into it where they can be cheaply financed. Or, if WPZ’s yield remains high they may retire some LP units. Having WPZ remain out there is, in ETE’s view, a good thing. It shows that the decisions get made by the owners of the MLP GPs, not the MLP unitholders themselves. As we’ve said before, the MLP GP is like a hedge fund manager.

LNG Exports Will Soon Commence

A question I’m often asked is how the business prospects of many MLPs will respond permanently to lower prices for oil and gas, perhaps lower than where they are today.

From a high level, markets often appear vulnerable to a correction. This is especially true with the S&P500. You rarely hear anyone simply say the market looks cheap, and in fact it’s easy to find reasons to worry. Today it’s rising rates and the threat of Grexit, but there’s always something to worry about. And if there isn’t, then you can worry about complacency. For me, the solution is to look at individual companies, because while the market outlook can be uncertain, the prospects for (fill in the blank) corporation often appear far more tangible and clear than for the broader averages.

The same is true with MLPs. Prices have fallen along with the energy sector. So look at Cheniere Energy and their LNG export facilities at Sabine Pass, LA and Corpus Christie, TX. It may seem quaint to remember, but not that many years ago the U.S. was preparing to import LNG. The two abovementioned facilities were built for that reason, until the boom in domestic natural gas production led to a glut and rendered the economic assumptions underlying imports no longer valid.

So the facilities were switched to export LNG instead. This is not a trivial task. Natural gas has to be compressed and cooled to around -256 degrees Fahrenheit before being piped into the large spherical tanks you see on LNG tankers. Handling LNG is far harder than crude oil, and the regulatory oversight is substantial as you might imagine. An accident at an LNG terminal would be a spectacular sight as long as viewed from many miles away.

Cheniere’s CEO Charif Souki has a substantially bigger risk appetite than ours, as I’ve written before (see U.S. Natural Gas Terms of Trade Continue to Shift) but he is close to starting operations at the first LNG export facility in the lower 48 states. The relevance to MLPs of this milestone is that the natural gas that Cheniere will export has to be transported to their terminals via pipeline and stored prior to processing and loading onto LNG tankers. Two important infrastructure providers are Kinder Morgan (KMI) and Williams Companies (WMB). KMI announced plans to provide pipeline capacity and storage for Cheniere’s Corpus Christie facility back in December.

WMB will be expanding its Transco pipeline network, an enormous connection of pipelines and supporting infrastructure running down the eastern U.S. from the north east to Texas. Last year they announced they’d be building Gulf Trace which will bring natural gas from the Marcellus Shale in Pennsylvania down to the Sabine Pass LNG export terminal and from there to foreign customers.

The question of whether low commodity prices are good for energy infrastructure is not one that can be answered with a simple “yes” or “no”. The LNG export projects provide an example of how the domestic energy business is exploiting opportunities from low domestic prices.

We are invested in KMI and WMB.

Interesting Perspectives from Plains All American's Investor Day

Plains All American Pipeline (PAA) held their Investor Day on Thursday. The presentations included a fascinating analysis of the global oil market with a view to forecasting prices as well as regional supply/demand, since these are important drivers of PAA’s planned infrastructure development. The chart at the left, reproduced from PAA’s Investor Day deck, plainly shows the impact of growing North American output on the global market. Since 2011 global supply has increased by a little over 4 MMB/D, 1.4MMB/D in excess of demand growth which is why inventories have groWorld Petroleum Supply Growth PAA June 2015wn. Moreover, North America has met more than 100% of this increase in global demand, since output in the rest of the world has net fallen somewhat. This simple graphic illustrates as well as anything that the Shale Revolution in the U.S. has not just been a North American story but has impacted the global oil market, most obviously through the drop in prices since last Summer.

A corollary to this is that growing U.S. production is reducing import demand, as U.S. refiners process more domestic crude oil. However, U.S. refineries are generally better able to process the heavy crude that we’ve historically imported, and the light sweet crude that is typically produced from domestic fields is not as good a fit for many refining facilities. There are also distribution bottlenecks which are gradually being alleviated, but in combination these two factors along with the ban on crude oil exports account for the discount of WTI crude compared with Brent.

The export ban dates back to the 1970s, and looks increasingly anachronistic today. You might expect the oil industry (excluding refiners who benefit from captive suppliers) to favor repealing the export ban. Greg Armstrong, PAA’s CEO, acknowledged the free market argument in favor of doing so but also conceded limited political support for such a move. It would seem intuitive that allowing domestic oil to be sold overseas would raise its price and therefore increase the cost of domestic refined products, including gasoline, which explains the limited political support.

Surprisingly though, quite a number of independent studies have concluded that allowing U.S. exports of crude oil would lower domestic gasoline prices. The analysis predicts that selling U.S. oil on the world market would increase global supply and further stimulate domestic production, thereby lowering gas prices. It’s not obvious; unsurprisingly,  the American Petroleum Institute makes the case but among the many sources they cite are included the Federal Reserve Bank of Dallas and the Congressional Budget Office, two entities not that connected to E&P. So although political support isn’t strong today, the economic case is more supportive than you might first think. Lifting the ban would be good for the domestic energy industry including infrastructure.

On a different topic, Greece is once again in the news as another critical deadline approaches. It may not be much appreciated or even known by their creditors, who are now largely the IMF and the ECB, but as I wrote in Bonds Are Not Forever, since gaining independence from Turkey in 1822 Greece has been in default approximately 50% of the time. Given this checkered history as a reliable debtor, the repayment expectations of Greece’s creditors are barely credible. Under the capital guidelines on developed country debt in force prior to the 2008 financial crisis, Greece’s debt drew the same capital requirements as Germany’s for those banks which held it (which were numerous), in willful defiance of history as well as common sense. Much of that debt is now held by their current creditors, having been transferred from private hands to public in a prior renegotiation. But it seems to me that if it’s stupid to borrow what you can’t repay, it’s stupider to lend what probably can’t be repaid. Greece is an example of the general abundance of debt in the financial system. While not every borrower is Greece, today’s bond investors are offered an unlimited supply to choose from, yet at yields that would suggest scarcity. The thoughtful bond investor is switching asset classes.

We are invested in Plains GP Holdings, the General Partner of PAA.

The Enormous Misunderstanding About MLP Funds and Taxes

Inspiration for these posts often comes from conversations I’ve had with investors during the prior week. For a great many investors, the decision to invest in an MLP mutual fund or ETF goes something like this:

1) MLPs have generated attractive historical returns over (choose your time period) number of years

2) The yield on the Alerian Index is around 6%, which looks good.

3) But MLPs generate K-1s, which I don’t understand and my accountant hates

4) However, there are mutual funds and ETFs which invest in MLPs but give you a conventional 1099

5) I should invest in one of them

What this analysis misses is the heavy tax burden these funds endure, which sharply reduces the returns to investors. The conversion of K-1s received by the fund into 1099s received by the ultimate investor comes at the price of a 35% corporate income tax on those returns. So you’re going to receive 65% of what the fund actually receives on its investments.

There are many examples; let’s look at the Mainstay Cushing MLP Premier Fund (CSHAX), whose Fact Sheet reveals an expense ratio of 6.97% to 7.72% (depending on the share Class). They call it a “Gross” ratio (which is an apt name because it is pretty gross) to highlight that most of the expenses do NOT go to the manager. They go to the U.S. Treasury instead. These expenses are still borne by the investor though. CSHAX has returned between 5.7% and 7.1% (depending on share class) since inception in October 2010, compared with 9.4% for the Alerian Index. In fact, it correctly doesn’t compare its performance with the benchmark nor seek to achieve an equivalent return. It can’t.

Goldman’s MLP Energy Infrastructure Fund (GMLPX) has an expense ratio of 3.16% to 3.56%. Most of the MLP funds out there pay substantial taxes. Although MLP returns have been good — for example, the Alerian Index has returned 14.28% per annum over the five year period through April 2015 — the investors drawn to the sector by this history and the attractive prospects are unlikely to earn close to the returns of the index by investing through funds like these because of the tax drag.

Now that a few years of performance have revealed how poorly these funds do against the benchmark, the reality of the huge tax drag is becoming apparent to many investors.

It’s worth looking carefully at the MLP funds you own to see if you’re contributing substantial chunks of return to the U.S. Treasury. Not all funds are structured in this way. And those that are not subject to corporate income tax only need to earn 65% of the pre-tax return of the funds that are subject to the tax to do just as well for their investors. It shouldn’t be hard to do substantially better.