Pipeline Buybacks Are Coming

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

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

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

It’s beginning to look like a trend.  

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

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

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

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

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

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

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

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

Exxon’s Contrarian Bet

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On Wednesday Exxon Mobil (XOM) declared a quarterly dividend of 82 cents a share. Although this means 2020 will be the first year since 1982 that they haven’t raised it, the bigger question is whether they can sustain it.

We noted recently how energy investors could fare better under a Democrat administration (see Why Exxon Mobil Investors Might Like Biden). A White House looking for ways to combat climate change should cause energy executives to hunker down, constraining their desire to drill for oil and build new infrastructure. A pipeline owner should find this a welcome prospect, as less cash spent on new projects means more for buybacks, debt reduction and dividend hikes. XOM is positioning itself for such a scenario – they plan to increase oil and gas production from 4 million Barrels of Oil Equivalent per Day (MMBOED) currently to over 5 MMBOED by 2025. This bet is predicated on rising global demand driven by emerging economies combined with falling investment in new supply, as energy companies prepare for peak oil and the energy transition.

There’s something appealingly pragmatic about XOM’s positioning. Although growth in renewables gets all the attention, the world still relies on fossil fuels for more than 80% of its energy. In the U.S., the biggest increase in power generation in the first half of the year came from natural gas, not renewables. Most credible long-term energy forecasts show that the world will be using more of every type of energy, because developing countries want to raise living standards. The energy outlook embedded in XOM’s production plans is probably not consistent with the Paris Climate Accord. If you want to bet that the world will manage to live with a warmer climate, rather than achieve the reductions laid out by the UN’s Intergovernmental Panel on Climate Change, XOM might be a way to express that view.

If they’re wrong, that 82 cent dividend won’t last. Analysts estimate they need crude prices of at least $55 per barrel in order to generate enough cash to cover planned growth capex and pay their dividend. For now, they’re funding it with increased debt.

Given the energy sector’s sorry history of overinvesting in recent years, maintaining high dividends does impose greater financial discipline. It raises the required return on new spending, making dilutive projects less likely. Although financial theory teaches that dividends shouldn’t matter, investors increasingly recognize the protection against otherwise poor capital allocation decisions. That’s likely part of the reason XOM rose on Thursday, because it maintained a dividend that’s currently financed partly with debt.

Pipeline investors often must consider the viability of a company’s payout policy. The Alerian MLP ETF, AMLP, has cut by 50% since 2014. Although Energy Transfer (ET) just did the same early last week, the pipeline sector is entering a period of sharply rising Free Cash Flow (FCF). The trend towards reduced spending on new projects was well underway before Covid hit this year.

Energy has been chronically out of favor, so XOM and the American Energy Independence Index have tracked one another lower. Although the pipeline sector and XOM are both forecast to experience growing FCF, pipeline dividends will be comfortably covered by FCF while XOM’s will not, at least with current crude oil pricing. XOM offers a way to bet on higher crude. By contrast, pipeline stocks look cheap regardless.

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

Next Wednesday, November 4th at 1pm EST we’ll be hosting a post-election webinar to discuss the outlook for the energy sector. Click here to sign up.

Why Energy Transfer Cut Their Distribution

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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.

Hydrogen Lifts an LNG Company

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Few would believe there’s a midstream energy infrastructure stock that’s tripled this year, but New Fortress Energy (NFE) has done just that. Happily, it’s a component in the American Energy Independence Index (AEITR). This year’s strong performance has NFE approaching a top ten position, since AEITR is market cap weighted.  

NFE was founded in 2014 by Wes Edens, already a billionaire as a co-founder of Fortress Investment Group (FIG). They transport Liquified Natural Gas (LNG), and have five facilities located around the Caribbean and in Miami. NFE claims that their innovative use of smaller LNG ships makes clean natural gas available to ports that otherwise don’t have the infrastructure. These vessels are called Floating Storage Regasification Units.  NFE’s investor slides emphasize their ability to bring cleaner-burning natural gas to island nations such as Jamaica, thereby reducing their reliance on dirtier, oil-based fuels for power generation.  

NFE went public last year as an LLC electing to be taxed as a corporation, and earlier this year converted to a regular c-corp. Their stock performance was unremarkable – that is, it tracked AEITR – until early July when it took off.  

Although NFE already had a positive environmental story to tell, in recent months they have begun discussing plans to transport hydrogen, an emission-free fuel. So far, management has done little beyond muse on conference calls about their interest in hydrogen and how great it would be if the economics allowed it to compete with natural gas. There are no hydrogen-related revenues, and analysts don’t expect the company to make substantial capital commitments in this area.  

Nonetheless, there’s little else to justify NFE’s recent meteoric rise beyond its stated interest in hydrogen. The word came up 32 times in the 2Q earnings call on August 3rd (up from 12 in the 1Q call), although obliging questions from sell-side analysts helped. CEO Edens noted that, “75% of all of the elements in the universe are hydrogen, 24% helium, 1% other. So the world is full of hydrogen.” 

This doesn’t mean NFE won’t access new technology that makes hydrogen a commercially viable fuel. Pipelines and other infrastructure dedicated to natural gas might be repurposed to handle this zero-emissions fuel, which would transform the malaise felt by investors towards the sector. But NFE’s stock has shot up recently mostly on the hope of a breakthrough. NFE’s green hydrogen division (named Zero) has no revenues. But just having a business unit with that name can only help an energy company. 

NFE’s recent rise hasn’t been overlooked by other midstream companies. Kinder Morgan (KMI) chairman Rich Kinder included the words “green hydrogen” when he opened Tuesday’s earnings call. 

Thursday’s presidential debate touched on climate change. Regardless of who you’re voting for, there can’t be much doubt that Trump won the exchange. Biden’s talk of a moral imperative to reduce carbon emissions isn’t likely to resonate when the economy is virus-ravaged. Trump correctly noted that China and India plan to keep increasing their CO2 emissions for at least another decade. China burns half the world’s coal.  

This component of climate change realpolitik receives little popular attention.  Climate change policies aren’t currently costing much, unless you live in California where electricity is greener, more costly and less reliable. But if America does adopt policies to aggressively reduce emissions, Trump’s point is that many will balk at higher domestic energy prices when the biggest emitters remain focused on raising living standards. A Biden victory will lead to a more vigorous debate, exposing a huge flaw in the Paris agreement. 

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

Why MLP Fund Investors Should Care When They Change

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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.

Pipeline Technicals Turn Bullish

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Although we rarely write about technical analysis, charts are helpful in showing visually where prices have come from. We also have a good number of clients who use charts to form investment opinions. This is especially true when it comes to changing portfolio allocations. Recently, bullish energy sector charts have come up in conversations.

The 200-day moving average is widely used, and often gives a signal when crossed by a faster moving average, such as the 50 day. From 2016 to early this year, the pipeline sector stayed within a 20% range, and moving averages offered little of use to the technician.

Following the steep drop from January to March, the trading range for the American Energy Independence Index (AEITR) has become steadily tighter. Lower highs and higher lows will soon be resolved, as it breaks out of its current formation.

The 50-day moving average crossed the 200 day on Tuesday. Some may prefer to see it happen more decisively, with the 50-day moving sharply higher. Nonetheless, by this definition the sector has begun a new uptrend. The index itself has remained above both moving averages since Wednesday.

There’s also a downward sloping trendline, against which the index is bumping. A move up through this would confirm the bullish signal from the moving averages and chartists would interpret this as positive.

Proponents of technical analysis will tell you that it improves the timing of their trades. The fundamentals for pipelines have looked encouraging to us for several months now, with free cash flow set to double this year (see Pipeline Cash Flows Will Still Double This Year). We wrote that in mid-May, and it’s looking increasingly prescient with midstream energy infrastructure 6% higher since then. But with a yawning gap between yields on bonds and equity from investment grade issuers (see Stocks Are Still A Better Bet Than Bonds), there is substantially more upside. Fixed income markets are far more positive about big pipeline companies than are equity markets. Bond buyers have a reputation for doing more careful analysis, since their upside is receiving coupons and their downside is losing everything. They are right to be constructive.

Bullish fundamentals are now being confirmed by technical analysis.

Sentiment remains extremely cautious. Although we don’t have any numbers on this, conversations with investors often reveal interest in valuations but nervousness about buying just before a big drop. The energy sector has done that to people in the past. A lot of these people represent potential buyers – interested in committing capital but looking for some signs that they’re not alone. Waiting for the election is a common refrain. A Biden victory is priced in, and we think could be positive for pipeline stocks (see Why Exxon Mobil Investors Might Like Biden).

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

Natural Gas Prices Rise for Democrats

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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.

Pipeline Companies Should Buy More Stock

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The energy sector has long been criticized for reinvesting too much capital back into its business, without ensuring that such investments exceed their cost of capital. No business can survive unless its return on investments is more than the cost of financing them.

Equitrans Midstream Corporation (ETRN) has an opportunity to demonstrate that they understand this.

ETRN’s major initiative is the Mountain Valley Pipeline (MVP) project, a natural gas pipeline with 2 Billion Cubic Feet per Day (BCF/D) of capacity connecting the Marcellus shale in West Virginia with customers in southern Virginia. Environmental extremists have been using the courts to block MVP for years, but ETRN management remains confident in its ultimate completion — albeit less so on the timing.

The first stage of the project, including feeder systems Hammerhead and the Equitrans Expansion Project, is expected to cost $3.4BN and generate $320MM in EBITDA. So the initial investment has a cash-on-cash return of 9.4%, well below the company’s target of a mid-teens IRR.

ETRN management believes they could add another 0.5 BCF/D of capacity for just $200MM. This would generate an additional $65-70MM in EBITDA, a whopping 33.7% Return On Invested Capital (ROIC). Expansion projects often have high returns, since they leverage off existing infrastructure and face less uncertainty.

The expanded MVP should generate $385-90MM on $3.6BN of capital, a 10.7% return. ETRN clearly needs to complete MVP – most of the capital has already been deployed. And the expansion, with its 33.7% ROIC, is an easy decision. But how should they think about allocating capital in the future, once this project is done?

Currently, ETRN generates EBITDA of around 1.2BN. Following MVP’s completion, this will increase to $1,587MM, which we’ll round up to $1.6BN. A reasonable estimate of the sustainable cash flow to the owners is to start by deducting interest expense ($300MM on $6.4BN of debt) and taxes (which are currently zero as depreciation charges offset its taxable income). The company spends $75MM on maintenance capex, which is generally intended to offset depreciation and amortization, both of which are non-cash expenses. So the company will be generating $1,225MM for its owners.

ETRN’s 432 million shares at $8.60 give it a market capitalization of just over $3.7BN. Its cost of equity is therefore 33%.

A company is supposed to invest so that its ROIC is more than its Weighted Average Cost of Capital (WACC). In this case, assuming ETRN finances its assets with 50% debt which costs 4.7%, its WACC is 18.85%. Any project that fails to earn a return above this WACC is destroying value for the owners.

The disconnect between ETRN’s cost of equity and debt isn’t unique to them – it’s common across midstream energy infrastructure. Enterprise Products Partners (EPD) common units pay over a 10% dividend and trade at a 17% distributable cash flow yield, while it has 30 year debt outstanding yielding  under 4% (see Tech Stocks Have Energy). Stock and bond investors hold sharply different views on pipeline stocks.

When EPD canceled an $800MM investment in a crude oil pipeline recently, the stock rose because this meant more cash for buybacks (see Investors Like Less Spending).

What it means is that ETRN should consider buying back equity as a use of capital competing with any other investment they might consider. Although the MVP expansion offers an ROIC comparable to the company’s cost of equity, they don’t have any other projects that come close to earning that type of return. In fact, the company has indicated they are seeking a mid-teens internal rate of return on new projects, so they’re not even trying to beat their WACC.

This makes no sense, based on ETRN’s stock price. Too many companies regard growth projects as an unassailable part of their business, almost a raison d’etre. They have a culture of always building. It’s because they’ve ignored this type of math that pipeline stock prices are so low.

Once MVP is finished, ETRN will demonstrate their grasp of corporate finance based on whether they recognize that buying back their stock is the best use they can make of their cashflow. If instead, they pursue the next growth project with a projected return half their cost of equity and even below their WACC, they’ll be confirming their financial innumeracy.

Too many midstream CFOs find grasping their cost of equity an elusive concept. If the components of WACC were reversed such that the cost of debt was 32%, few projects would be more attractive than paying down debt.

The distortion in capital markets between debt and equity should compel the entire midstream sector to reassess how they deploy their free cash flow, which is set to grow substantially (see Pipeline Cash Flows Will Still Double This Year).

Even Targa Resources, a company with a long history of flunking the math of capital allocation (see Pipeline Buybacks and ESG Flexibility), recently surprised many by correctly initiating a buyback. As others follow, the boost to their stock prices will be substantial.

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

Pipeline Buybacks and ESG Flexibility

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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.

Devon Shows Occidental How To Buy

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The merger between Devon (DVN) and WPX Energy (WPX) offers a marked contrast to Occidental’s (OXY) ill-fated acquisition of Anadarko. Synergies are coming from cost savings not revenue opportunities, a defensive move that will likely spur further consolidation. The annual savings of $575MM will cover the modest 2.6% premium paid by DVN in less than two months. OXY paid a 62% premium 18 months ago.

The new Devon’s dividend policy has been well received – by paying out half the excess Free Cash Flow (FCF) over the current dividend, it allows investors to model different oil price scenarios and their impact on the payout. It’s another acknowledgment that bringing energy back in favor requires greater financial discipline.

A Biden administration has vowed to cease issuing new permits for fracking on Federal land, a policy that would constrain DVN’s Permian output. States benefit from the associated economic activity – the labor involved in drilling, fracking, transportation of water and other inputs to and from the site all create local jobs. In addition, New Mexico for example, where DVN has much of its Permian acreage, receives a 20% royalty. The Biden campaign’s promise to curtail fracking plays well with the base but is unlikely to be popular closer to the regions affected.

Switching gears, society is adjusting to life with Covid, where data continues to show positive trends. New Jersey, population 9 million with the worst fatality rate of any U.S. state, has 421 Covid patients in hospital, down 95% from the peak in April. We spend hours poring over the data, reading and learning about it. As chronicled before, your blogger doesn’t want to get sick and follows mask/hygiene protocols. But we think the market’s rapid recovery reflects the data – vulnerability increases sharply with age and certain risk factors. For the vast majority it’s not fatal.

Anecdotes also inform – here are some of ours:

One good friend at serious risk because of pre-existing health issues endured an extremely mild case of “Covid toes” – chilblains and nothing more. Once it was clear he was not in danger, I applied one of Winston Churchill’s many great quotes to him. “There’s nothing more exhilarating than to be shot at and missed.”

Another friend, in his late 50s and fit with no obvious risk factors, spent four days in hospital on oxygen (but thankfully not on a ventilator). His entire family was infected when their son returned from college. He’s recovered, but doesn’t care to repeat the experience.

The head of Trauma at a local hospital recounted somberly what his life was like in March and April. He’d never seen x-rays and conditions like those that presented. He’s hopeful it’s under control, but also noted that substance abuse is up sharply. Self-quarantines and the stress of financial losses are creating mental health issues.

Another friend recounted how her daughter, at college in Colorado, has endured a series of self-quarantines. As soon as one finished, she was found to have been in contact with another infected person and had to do another two weeks. This has continued for a couple of months, and the daughter is showing signs of mental stress.

My wife is a teacher, and modified in-person classes require wearing a mask all day. Although there’s no evidence than extended mask wearing causes any harm through oxygen deprivation, and it’s routine for health care workers, working with a mask on permanently is a lousy way to spend your day.

Then there’s the older woman in North Carolina who was sufficiently fearful of infection that she insisted her landscapers wear booties over their shoes. She brought home a case of diet coke, and out of an abundance of caution decided to sterilize the cans by placing them in her dishwasher. Well into the dishwasher cycle she was awoken in bed by a series of loud explosions, as the hot water ruptured the soda cans. Convinced her house was under attack, she alerted her neighbors.

Very little attention is being paid to the human and financial costs of mitigation, but we suspect that when a final reckoning is done it’ll be clear that cost-benefit analysis was completely absent.

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

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