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.

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