U.S. Natural Gas Terms of Trade Continue to Shift

Data recently released by the Energy Information Agency (EIA)  highlighted the continuing shift in U.S. terms of trade regarding natural gas. The North East U.S. (NY, OH, PA, NJ, MD, DE and VA) was for the first time in 2014 no longer a net importer of natural gas from Canada, as production in the Marcellus Shale in Pennsylvania finally grew so as to make the region self-sufficient. The Great Lakes states (MI, WI, MN) have been net exporters for several years, now joined by another region as defined in the EIA’s release.

Even though the North East is reducing its reliance on Canadian natural gas, there remain infrastructure bottlenecks in New England preventing sufficient peak supplies reaching customers. Boston paid as much as $30/MCF for natural gas this past winter to meet high electricity demand, and limited regional pipeline capacity is expected to cause continued seasonal spikes for the next few years. The states in the region have begun to co-ordinate their efforts to improve access to electricity, natural gas and renewables. Spectra Energy (SE) is just one of the energy infrastructure companies seeking support from state and local governments in the region for its plans to improve natural gas distribution.

In related news, the first LNG export facility in the lower 48 states is expected to begin operations later this year (The Kenai LNG export terminal in Alaska is currently the only source of U.S. LNG exports). The Sabine Pass facility in Louisiana is owned by Cheniere Energy Partners (CQH). It is run by a colorful character named Charif Souki, memorably portrayed in Greg Zuckerman’s 2014 book The Frackers. Last year CQH’s parent company, Cheniere Inc (LNG) was forced to withdraw its proposed compensation plan following investor lawsuits arguing it was too generous. Meanwhile, CQH spent $17MM on distributions to MLP investors last year, no doubt fostering a warm feeling about their stable business. However, unlike most MLPs, distribution coverage isn’t a useful metric since CQH has no revenues yet. One wonders how many unitholders actually know that. No doubt when  the Sabine Pass facility begins operations their income statement will look wholly different, but this was one name that didn’t make it through our screening process, although LNG exports remain a fascinating story.

As an aside, in a previous career as a restaurant operator Souki had the misfortune to own the L.A. restaurant where Nicole Brown Simpson, OJ Simpson’s wife, last ate prior to being murdered in 1994. Souki’s business career includes episodes of near-bankruptcy and it’s fair to say he and I have different risk appetites. However, having successfully converted Sabine Pass from an LNG import facility to one that exports, he’s likely to be one of the winners from U.S. energy independence.

Of the names mentioned, we are invested in SE.

Another MLP Simplification Benefits From Favorable Depreciation Rules

Last week Williams Companies (WMB) simplified their structure by acquiring the assets of their Master Limited Partnership (MLP), Williams Partners (WPZ). As was the case with Kinder Morgan’s (KMI) move last year, the objective was to move to a simpler structure with a lower cost of equity driven by faster dividend growth supported by a bigger tax depreciation shield. Although the effect wasn’t as big as with KMI, WMB was similarly able to take advantage of depreciation rules that allow assets acquired from a partnership to be written up to current market value, thus creating a higher level from which tax-deductible depreciation can be made. This contrasts with the rules that apply when a corporation is acquired, whereby the excess over book value paid by the acquirer is reflected as an intangible asset (goodwill). No similar depreciation of goodwill is allowed. Given the choice, you’d rather buy assets from a limited partnership than a corporation, since in the depreciation rules are more favorable. WMB expects to realize a $2.1 billion benefit over 15 years from this stepped-up cost basis which will support a dividend growth rate of above 10%. Its 4.9% yield looks attractive.

Regular readers of this blog might have started to feel that we never come across an MLP General Partner that we wouldn’t like to buy. Although we think the sector is attractive, this isn’t true of every security. EQT GP Holdings (EQGP) recently started trading following its IPO. EQM Midstream Partners (EQM) is an MLP focused on natural gas gathering, storage and transmission in the Marcellus shale in SW Pennsylvania and West Virginia. EQGP is its GP, with Incentive Distribution Rights over its cashflows.

We were potentially interested in EQGP depending on pricing. However, its forecast first year distribution of $0.365, even if combined with a heady growth rate of 40%, had us thinking that a mid-$20’s price for the IPO would be a full price but probably justified because of the growth outlook. The IPO buyers regarded us as needlessly conservative however, and EQGP commanded a low $30’s price from inception. Too rich for us; we’ll wait for another pitch.

Of the names mentioned, we are invested in KMI and WMB.

MLPs Start Reporting 1Q Earnings

Several Master Limited Partnerships (MLPs) announced their quarterly earnings last week. The overall picture continues to be one of businesses performing well with good distribution coverage and continued plans to grow their infrastructure networks while responding appropriately to shifts in the domestic production landscape.

So Enterprise Products Partners (EPD), an MLP with no Incentive Distribution Rights (IDR) drag detracting from its investors’ returns, announced their 43rd consecutive distribution increase of 5.6% compared with a year earlier. Their payout is also covered at 1.4X by Distributable Cash Flow.

Oneok Inc., (OKE) the General Partner (GP) for Oneok Partners (OKS) was a more nuanced story. The stock price fell following the earnings release as the distribution remained flat on a quarterly basis (+8% on a year ago). Of note was that cashflows to OKE from OKS, reflecting its role as OKS’s GP, were $169MM, +16% on a year ago. Interestingly, Net Income and DCF at OKS itself fell in 1Q15 compared with the prior year. They explained it so, “Variances in financial performance between the first quarter 2015 and first quarter 2014 were primarily a reflection of significantly higher weather-related seasonal demand, resulting in higher prices for propane and natural gas, in the Midwest due to severely cold weather during the first quarter 2014 and the continued impact of commodity price declines in the first-quarter 2015.”

A cold 2014 winter and lower commodity prices this year affected earnings. The GP experienced more stability in its earnings than was reflected in the underlying MLP it controls. Nonetheless, full year guidance was confirmed as unchanged both for OKS and OKE. OKE’s coverage of its distribution was 1.2X which prompted one analyst to ask on the earnings call whether OKE might even use some of its cash to buy OKS units on the open market. You could interpret the absence of a dividend hike by OKE as symptomatic of a tougher business environment, or you might regard their resulting comfortable distribution coverage as reflecting an abundance of caution. We lean towards the latter.

Overall, for these two MLPs, business seems to be going well. We are invested in EPD and OKE.

Energy Insights from Enterprise Products Partners

We noticed several interesting slides from an investor presentation by Enterprise Products Partners (EPD) recently. The first concerns future capital investment plans of Master Limited Partnerships (MLPs). As you can see on the first chart, lower oil prices have caused some moderation in forecast capitaEPD Shot of Organic Growth Capex May 2015l expenditures (“capex”) and a drop in 2016 versus 2015. However, the numbers remain substantially higher than the pre-2013 period, and support the forecast of $30-50BN in annual capex for energy infrastructure (since while MLPs are the main operators of such assets, integrated oil companies and utilities also fund energy sector projects).

Part of the MLP story in recent years has been the growth in infrastructure build-out to support the exploitation of shale assets. While the rate of growth is flattening out, projected asset growth at MLPs remains strong. Just as hedge fund managers benefit from asset growth in hedge funds, so should MLP General Partners expect to benefit from runningEPD Shot of New Projects Using Cheap Domestic Energy May 2015 bigger MLPs.

Another interesting slide concerned the growing interest in petrochemical facilities to take advantage of cheap natural gas in the U.S. As the table at right shows, the U.S. is fast developing a healthy trade surplus in petrochemicals exports.

Perhaps the most interesting insight was contained in the third chart, highlighting where oil production has been growing and where it hasn’t. As the chart title asks, “Why Couldn’t OPEC perform?” The rational response to the steady increase in oil prices over the past decade (albeit with a substantial fall and recovery in 2008-9) caused by growing demand from emerging economies should have been to match that increase with higher output, thus arresting the price increase and rendering other, unconventional sources of crude oil production uneconomic while still at a nascent stage. But OPEC, and most notably Saudi Arabia, failed to take this logical step. This created the opening for North American output to develop, meeting the increased demand while lowering its unit cost of production through economies of scale and ongoing technological improvements.

That OPEC didn’t do this suggests that they couldnEPD Shot of Oil Production May 2015‘t, and highlights the difference between very low production costs for proved, developed reserves in the Middle East versus relatively high costs to develop new resources beyond what is already in production. Clearly, from the perspective of a group of producers that still satisfies roughly one third of global oil demand, a modest increase in output to maintain market share and render new sources of supply uneconomic early on would have been a far less costly strategy than the current one of maintaining fairly constant output regardless of price. It suggests that even countries such as Saudi Arabia have a fairly limited capacity to increase output over the short term.

North American shale production, with its ability to adjust output quite quickly in resopnse to price changes, is turning out to be the swing producer. If this analysis is correct, it should result in a more stable oil price than we’ve seen in the last year since a more flexible supply response to price movements now exists.

The U.S.'s Self-Imposed Oil Embargo

In an interview on CNBC last week, Continental Resources CEO Harold Hamm elegantly exposed the increasingly anachronistic ban on crude oil exports from the U.S. By noting that sanctions on Iran would soon be lifted, allowing that country to once again export oil, he characterized the U.S. export ban as a self-imposed sanction, benefiting other producers and certainly not helping the U.S.

It’s an obvious contrast to draw, and such a devastating soundbite targeted at the dwindling supporters of maintaining current law, which dates back to the 1973 Arab Oil Embargo when the world was a very different place. Some believe that U.S. producers could realize an additional $5-14 barrel by selling to overseas customers. Other 1970’s era energy-related laws such as price controls and rationing were dropped long ago. In fact, arguably the main beneficiaries of current law are domestic refiners who are able to buy crude oil in a domestic market with fewer options than it might otherwise have.

Alaska’s senator Lisa Murkowski has promised to introduce legislation repealing the ban. Ever since oil began its collapse last Summer, hurting employment in a booming domestic energy industry, the ban has received increasing attention. Conventional wisdom continues to hold that the status quo will prevail. This may be so, but sometimes a position can be summed up in a soundbite that works for TV or for a speaker on the Senate floor looking for a 10 second clip on the nightly news. The contrast between lifting sanctions on Iran and maintaining our own self-imposed one is a powerful one easily communicated in a single sentence. It just might shift the debate, since articulating the opposite view doesn’t offer anything like the same optics or brevity of response.

If the oil export ban is eventually lifted, it’ll benefit a number of Master Limited Partnerships (MLPs) that have assets that handle liquids, including Magellan Midstream (MMP), Energy Transfer Equity (ETE), because of its ownership of the GP in Sunoco Logistics (SXL), and Plains GP Holdings (PAGP). Other MLPs, such as Targa Resources (TRGP) and Enterprise Products Partners (EPD) have Gulf Coast based assets that would also benefit from increased movement of crude oil through the Gulf on its way to foreign markets. We are invested in all the names just mentioned.

The Voting Control of an MLP GP

The other day someone was asking me for a simple explanation of how MLP General Partners (GPs) enjoy a superior position to those of the LP unitholders in the MLPs they operate. There are many ways to show that, but I thought I’d pull some information from the recent 10K filed by Plains All America (PAA), a well regarded MLP that’s  controlled by its GP, Plains GP Holdings (PAGP).

Highlights from the 10K include:

“Our general partner manages and operates the Partnership. Unlike the holders of common stock in a corporation, unitholders will have
only limited voting rights on matters affecting our business. Unitholders have no right to elect the general partner or the directors of the general
partner on an annual or any other basis.”

In other words, owning units of PAA won’t allow you to influence the business.

“In addition to distributions on its 2% general partner interest, our general partner is entitled to receive incentive distributions if the
amount we distribute with respect to any quarter exceeds levels specified in our partnership agreement. Under the quarterly incentive distribution
provisions, our general partner is entitled, without duplication and except for the agreed upon adjustments discussed below, to 15% of amounts
we distribute in excess of $0.2250 per unit, 25% of the amounts we distribute in excess of $0.2475 per unit and 50% of amounts we distribute in
excess of $0.3375 per unit.”

This illustrates how the GP gets an increasing portion of the cash generated by PAA. Even if PAA grows its business by issuing new debt and equity to fund expansion, the GP is entitled to its share of this bigger business without having to put up additional capital. It’s like a hedge fund or private equity manager. 

And although it turns out that a two thirds vote of the LP unitholders can result in the ouster of the GP, there’s this little gem:

“…generally, if a person acquires 20% or more of any class of units then outstanding other than from our general partner or its
affiliates, the units owned by such person cannot be voted on any matter;”

Owning more than one fifth of the LP units means you lose your vote, so it takes a minimum of four independent owners of a block of securities acting in concert to get around this. 

PAA is a very well run business with highly regarded management, so there’s little reason for investors in PAA to be dissatisfied. But given the preferential economic and governance rights described above, if you can control PAA through ownership of PAGP, why wouldn’t you?

On another topic, last June shares in Targa Resources Corp (TRGP) closed at $150 on hopes Energy Transfer Equity (ETE) was about to buy the company. When the deal fell apart TRGP’s stock fell.  Little more has been heard on the topic, and much has happened in the energy sector since June including a collapse in the price of crude oil. In the meantime, TRGP trades at $100, down by a third or more from its potential value in a deal last June. TRGP recently acquired Atlas Pipeline Partners and Atlas Energy, increasing its asset footprint.

TRGP yields 3.2% and its dividend has been growing at 29% annually, likely making it an accretive acquisition for ETE whose CEO Kelcy Warren is looking for M&A opportunities exposed by the drop in crude oil.

We are invested in PAGP, ETE and TRGP.

Follow the MLP Money

We’ve long advocated investing in the General Partners (GPs) of Master Limited Partnerships (MLPs) rather than the MLPs themselves. Most importantly, the GPs have preferential economics in the form of Incentive Distribution Rights (IDRs) which entitle them to up to 50% of the Distributable Cash Flow (DCF) the underlying MLP generInsiders Prefer GPs Original Chart Largerates. This entitlement is immune to additional issuance of equity, so GPs in effect maintain their economic stake even while the MLP grows its asset base funded with new issuance of equity and debt. In this way, MLP GPs are like hedge fund managers, in that asset growth always benefits them economically. MLP LP unitholders are similar to hedge fund investors in that asset growth may benefit them depending on the return on those additional assets.

MLP sponsors have long recognized  the benefits of the GP. It’s most powerfully illustrated in the chart at left (source: SL Advisors) showing insider ownership of GPs versus the underlying MLP. By a factor of 28:1 the money invested by the people who run MLPs favors GPs over the underlying MLPs. Not every MLP has a GP. Some have bought their GP back, creating a single class of equity. But where an MLP has a GP, if you invest in it you’ll most likely be aligning your interests with the insiders. By a factor of 28:1.

 

Unusual MLP Debt/Equity Issuance

Master Limited Partnerships (MLPs) performed poorly last week, with the Alerian Index dropping 4.3%, bringing it to -7.7% YTD.  The yield on the index is now around 6.4%, 4.3% above the ten year treasury which is historically an attractive level. There were a couple of unusual financing transactions undertaken by MLPs over the past week. One was the issuance by Kinder Morgan (KMI) of Euro-denominated debt. They issued €1.25BN divided between seven and twelve year maturities. KMI has no natural need for Euros since their business is all in North America, and because they don’t operate there one might think that European investors wouldn’t be that familiar with them as an issuer. Nonetheless, KMI was able to issue seven year debt at 1.50% and 12 years at 2.25%. These yields are lower than what they’d pay in the U.S., and while it’s tempting to suggest that the declining € was an additionally attractive feature (since if the € is weaker against the $ when the debt matures that will create a further gain for KMI), such transactions typically involve a currency hedge, since KMI’s business is about running pipelines not speculating on FX rates.

But even with the hedge, it likely represents attractive financing for KMI and reflects a positive view of their investment grade debt outside the U.S.

Another unusual piece of financing came from Targa Resources Corp, (TRGP). TRGP controls Targa Resources Partners LP (NGLS), and while equity is normally issued at the MLP level, in this case the C-corp which owns the General Partner (GP) and Incentive Distribution Rights (IDRs) for NGLS carried out a secondary. They raised $292 million which could increase to $336 million if the underwriters exercise their 30 day option to buy additional shares. In effect it increased the stock component of TRGP’s earlier purchase of Atlas Pipeline Partners and Atlas Energy which closed at the end of February. Pure-play GPs need never issue equity because they don’t have any assets to finance. However, TRGP is a C-corp that owns and controls physical assets in addition to NGLS’s IDRs. As a result of the additional equity, TRGP’s Debt/EBITDA will come down to a pretty conservative 2.9X since they’ll use the proceeds to pay down part of the revolver that helped finance the Atlas acquisition.

The other bit of news was that the IRS will once again begin issuing Private Letter Rulings (PLRs). A company contemplating dropping assets into an MLP structure can approach the IRS and request a specific ruling on whether the proposed transaction will qualify as an MLP. The IRS had stopped issuing these almost a year ago so it could review the law and come up with coherent regulations to guide its decisions. The resumption of MLP related PLRs will be welcomed by companies whose planned drop-down transactions had been on hold during this period of time. In our view the trend had previously been towards a somewhat more liberal interpretation of the types of assets eligible to be placed in an MLP structure. So far there’s been no indication from the IRS about the results of their 11 month internal deliberations, so we’ll find out as new transactions are made public.

We are invested in KMI and TRGP.

Two Examples Revealing the Power of the MLP General Partner

Tetra Technologies (TTI) is a small oil and gas services company. Small cap energy was perhaps the least pleasant place to be invested since last Summer, and TTI’s stock duly fell from $13 last Summer to $5 recently (it closed on Friday at $5.38). TTI owns 42% of Compressco LP (CCLP), an MLP that provides compression services all along the natural gas value chain from the wellhead to gathering and processing, storage and distribution. The value of TTI’s LP interest in CCLP is $230MM based on Friday’s market prices. However, TTI also owns the General Partner (GP) for CCLP. Although the GP Incentive Distribution Rights that TTI received was less than $1MM in 2014, CCLP’s growing cashflows will soon be lifting TTI’s split up towards the 50% maximum of CCLP’s Distributable Cash Flow (DCF). CCLP has a conservative 1.7X coverage on its distribution. But based on the outlook for its DCF growth, we think these IDRs could soon be generating $20MM annually for TTI. Applying a 30X multiple (a reasonable assessment for GP IDR cashflows) values just TTI’s GP interest in CCLP at around $575MM. That’s without including any value for the 42% of LP units that TTI already owns, or TTI’s other energy services businesses. TTI expects its LP interest in CCLP to generate $32MM in DCF in 2015. This is worth $400MM, or $5 a share at TTI’s multiple or at CCLP’s current price, which seems undervalued with an 11% yield and 1.7x coverage, $244M  (about $3 per share of TTI).

TTI’s current Enterprise Value (EV) is $834MM and its market cap is $432MM. GAAP accounting requires that TTI consolidate CCLP’s debt on its balance sheet although CCLP’s debt is not guaranteed by TTI. On this basis TTI’s EV is $1.3BN, and likely makes TTI’s balance sheet appear more leveraged than it will soon when the GP IDRs start generating more cash.

TTI has a legacy E&P business (Maritech) that has been a significant drag, but they should be finished with its remaining liabilities this year. The rest of TTI’s business should be able to generate around $80MM in free cash flow annually. We think we could be close to an inflection point in CCLP’s ability to generate increasing cashflows which will reveal the value in the IDR’s TTI owns as they move up to higher splits. We think TTI has substantial upside from current levels. Although TTI is not traditionally regarded as an MLP GP, much of its potential upside comes from that element of its valuation.

Another interesting transaction that took place earlier in the week concerned the acquisition by Western Gas (WES) of Anadarko’s (APC) 50% interest in the Delaware Basin JV gathering system. APC is WES’s sponsor. What’s unusual about this deal is WES doesn’t have to pay for the assets it’s acquiring until 2020. At that time, it will pay eight times average 2018-19 EBITDA less capex. WES will receive cash from its newly acquired assets immediately, and of course so will Western Gas Equity Partners (WGP), the GP of WES that is still 88% owned by APC. Paying for something in the future at a reasonable multiple based on its performance while enjoying cashflows immediately doesn’t happen every day, and in this case required the benevolent control of WES by APC. WGP benefitted without having to contribute any capital to the transaction, once again illustrating the power of the GP.

We are invested in TTI and WGP.

Why Boston Pays High Prices For Electricity

Natural gas prices vary widely — not just seasonally (electricity generation for summer air conditioning and winter heat create a familiar wave pattern to prices) but also regionally. It’s well known that natural gas prices are higher in many parts of the world than in the U.S. Probably less well knownn is the regional differences that occur within the 48 contiguous states.

The starkest contrast must be between North Dakota, where gas is flared because the infrastructure is not in place to move it, and New England where insufficient infrastructure exists to service peak periods. This night-time satellite image from NASA shows the many illuminated metropolitan areas, but the area denoted by the rectangular box is how the flaring of natural gas in the Baaken Shale in north Dakota (a very non-metropolitan area) appears. The excess methane is produced along with crude oil, and for now there is no place for it to go. The CO2 produced by flaring is the equivalent of 1 million new cars on the roads. Regulations are already being tightened; the amounts flared have fallen from 35% of methane produced in 2013 to 26%, and the goal is to reduce it further to 15% or lower by 2020.

Meanwhile, as everybody living in northern states knows, this has been another bitter winter. Boston had to suspend local regulations in order to dump snow into Boston harbor, since they had run out of places to put it. Less well known is that the price of natural gas in New England reached $19 per MBTU recently. This compares with spot prices of around $3 at the Henry Hub. The price in Willliston, ND, as shown by the flaring in the satellite photo, is zero.

New England’s energy infrastructure is widely acknowledged to be inadequate to the task. Some of the problems are self-inflicted, including a reluctance to invest in fossil fuel infrastructure in the hope of more “green” alternatives. Kinder Morgan’s (KMI) proposed pipeline from Pennsylvania has run into heavy local opposition, even though 45% of the region’s electricity is produced by burning natural gas. There’s also been a reluctance to make greater use of electricity produced across the border by Ontario Hydro.

New England suffers from other challenges of geography though. Situated on the coast, it is not on the way to anywhere which means any pipeline built is going to stop there. And the region suffers from extreme cold which causes spikes in energy usage, as we’ve seen recently.

This does highlight the ongoing need for new energy infrastructure though. Abundant supplies of natural gas are in North Dakota as shown, and (more relevant for Boston) also in Pennsylvania. It hasn’t been as easy as you might think for New Englanders to benefit from this reasonably accessible supply, but there are plans in place to resolve the bottleneck. Spectra Energy (SE) has an initiative called Access Northeast which is designed to supply more gas at affordable prices for electricity generation. The governors in the region have also been working together seeking an improved situation.

The point of this is that the global price of oil has very little to do with the need for improved peak supply of gas in Boston. Companies like KMI and SE are pressing ahead with these and many projects where traditional concerns such as regulatory approvals, easements, construction costs and financing are more important than the price of oil. For cold Bostonians paying temporarily high prices for electricity, such improvements can’t come fast enough. We are invested in KMI and SE.

 

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