Greta Thunberg’s speech at the United Nations may have grabbed the climate change headlines. But for those who find policy prescriptions from someone not yet out of high school a publicity stunt, the Energy Information Administration’s (EIA) 2019 International Energy Outlook was more interesting.

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The UN’s Intergovernmental Panel on Climate Change (IPCC) wants the world to reduce man-made net CO2 emissions to zero by 2050, in order to limit global warming to a further 1.5 degrees C. By contrast, the EIA expects energy-related CO2 emissions to grow at 0.6% annually, a third of the 1990-2018 rate but nonetheless in the wrong direction. This is because the EIA forecasts world energy use to increase by nearly 50%, with virtually all that growth in non-OECD Asia (often referred to as Asia ex-Japan).

According to Climate Tracker, only two countries (Morocco and Gambia) are on track to meet their goals under the 2015 Paris Agreement, which turned the IPCC’s recommendations into governmental commitments.

The goal of lowering emissions is at conflict with many other UN goals, such as eliminating poverty and hunger, and ensuring access to clean water and sanitation. Non-OECD countries are generally where these goals need to be met, and their pursuit is increasing energy consumption. The rich-country OECD world wants reduced CO2 emissions while poorer non-OECD countries additionally want higher living standards.

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The charts in the EIA’s outlook provide a sobering picture of the incompatibility of these objectives. Rising non-OECD living standards will by 2050 remain still 25% less than in the OECD today, and less than half the 2050 rich world level. This is in spite of growth in world energy consumption being fully taken up by non-OECD countries. Indian per capita residential energy consumption is still expected to be less than a quarter of U.S. by 2050.

Emerging Asia is the major source of this growth. India’s population is projected to surpass China’s over the next couple of decades, driving India’s faster GDP growth and also making India the fastest growing user of coal. China will remain biggest overall.

Growth in Indian electricity demand will be primarily met with renewables. It’s easier to shift your mix of power generation when consumption is growing. Yet India will still double its output from coal-fired power plants.

The reason almost none of the signatories to the Paris Agreement are on track to achieve their emission goals is that public support is broad but shallow. One survey found most U.S. households wouldn’t spend more than $10 per month to fight climate change.

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Yet, dramatic reductions in emissions require substantial lifestyle changes with more expensive energy. Renewables are slowly gaining market share, but regardless of the promises of environmental extremists, all serious forecasts show fossil fuels remaining the world’s dominant source of energy. The EIA projects that we’ll be using more of all sources of energy. Consumption of petroleum and other liquid fuels will grow by 20%; natural gas by 40%. Renewables are expected to almost double their share of world energy, to around 28% by 2050, but satisfying growing global energy demand will require substantial growth in hydrocarbons.

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Few Americans realize that the U.S. would need to reduce its CO2 emissions by around 15% over the next decade to meet its pledge, and that we’re generating 3.5X the amount that’s scientists believe is consistent with 1.5 degree planetary warming. If the U.S. had a plan to meet its pledge on emissions reduction, cost would quickly become an issue.

A big shift to renewables in the U.S. would raise the cost of energy. This is indisputable, because otherwise renewables would already be dominant. Climate extremists rarely discuss the costs, whereas we’ll need to make informed decisions about costs versus benefits.

Moreover, those most exposed to rising sea levels live in poor countries where emissions will continue to increase in order to raise living standards. Rich countries are far better able to manage the effects of changing climate. No U.S. politician has yet had to explain why Americans should pay more for energy in order to protect other countries from rising sea levels, even while those countries increase CO2 emissions. Trump’s planned withdrawal from the Paris Agreement next year is grounded in domestic political reality.

Paris pledges allow India, China and other non-OECD countries to continue increasing their emissions, acknowledging that increased living standards require more energy. While there is a moral argument in support of higher CO2 emissions from poorer countries, U.S. public opinion is untested on the issue of expensively curtailing domestic emissions to accommodate more output elsewhere. This will eventually be a significant political problem. Domestic environmental extremists are completely mis-directed. Growth in emissions is coming from Asia.

How will the world resolve its conflicting goals?

There are some sensible solutions: Federal standards and fast-track approval process for nuclear energy, which is clean and safe; phase-out coal with its harmful emissions in favor of cleaner natural gas; a carbon tax; Federal R&D into cleaner use of what works, which is fossil fuels.

All these steps and more will be needed to tackle the problem. Unfortunately, Democrat solutions such as the Green New Deal (see The Bovine Green Dream) and banning fracking are hopelessly impractical. Because their ideas have little prospect of implementation, Republicans aren’t pressured to offer alternative ideas.

The EIA’s report shows what world energy consumption will look like without significant changes in policies. Practical, centrist solutions that acknowledge trade-offs will be needed to develop deeper support for combating climate change. Voters will want to understand what they’re paying for. Until that happens, fringe policy prescriptions will scare people away. Greta Thunberg’s political grandstanding isn’t helping.

For constitutional observers, each weekly Brexit installment leaves viewers on the edge of their seats, pondering what further twists in the drama remain. Most recently, England’s Supreme Court ruled against Conservative Prime Minister Boris Johnson’s suspension of Parliament. Intended to stifle parliamentary debate during the run-up to Britain’s next Brexit deadline of October 31, the PM had argued that the extended closure was a normal prorogation leading to the Queen’s speech opening parliament’s next session. Nobody was fooled, and Johnson has in effect been found to have provided illegal advice when he asked the Queen to suspend Parliament. Great embarrassment for PM and Monarch. Civil wars are fought for less.

Johnson’s premiership opened shakily last month. He lost four straight votes while Parliament passed a law preventing a hard Brexit. The PM had pledged to leave the EU on October 31, with or without a deal, and Parliament disagreed. He then tried to call an early election. But the opposition preferred him in office but not in power for a few more weeks, so voted that down too. The PM subsequently kicked 21 MPs out of the Conservative party, including Nick Soames, Churchill’s grandson.

As a vocal Brexit supporter, it’s entirely appropriate that Boris Johnson should be in power right now, so as to carry the burden of the policy he championed, and to explain any disruption in its execution.

The country where I grew up has suffered from a complete void of competent political leadership in recent years. David Cameron’s decision to hold the referendum on Brexit in 2016 unleashed the divisiveness that has dominated UK politics ever since. Leaving the EU is far too complex to be based on a simple Yes/No vote. It should have been fought through a general election, with the winner responsible for carrying it out. Except that none of the major political parties supported Brexit, a political gulf starkly exposed by the referendum. When politicians don’t reflect voters’ views, populism follows. It is democratic, if unsettling

If you know someone’s location you can pretty much guess how they voted. London and other large cities along with Scotland and Northern Ireland voted to remain, while suburban and rural England voted to leave. No wonder the Scots may seek independence from the UK, as they’re dragged unwillingly out of the EU. Although the vote was close (52%:48%), and didn’t provide any view on what type of EU exit was approved (though it probably wasn’t a hard Brexit), polls suggest that few voters’ positions have since moderated.

People regularly ask me how it’ll turn out. I don’t think anyone can be sure. Since Parliament has outlawed Brexit with no deal, but also failed to approve Theresa May’s exit deal when she was PM, another delay is possible. Johnson could negotiate a revised exit agreement and get it through Parliament, which will now be reconvening earlier because of the Supreme Court decision. But he’s lost his majority by ejecting Conservative MPs who previously voted against him, so he may fail in getting his deal through too.

Another Brexit delay would lead to a general election, on which Brexit would finally be the defining issue. It’s recasting normal voting patterns. The Conservatives are unambiguously the Brexit party.

Labor is led by Socialist Jeremy Corbyn, whose main accomplishment has been to offer such a dystopian vision of Britain under his premiership that Theresa May clung to power far longer than her inept negotiations should have allowed. Labor’s Brexit position is ambiguous, an odd posture when it’s the country #1 issue. They’re choosing strategic flexibility at the cost of votes.

The Lib-Dems are the Remain party. But they routinely run a distant third, which renders their popular vote vastly under-represented in Britain’s first past the post electoral system. Hence, Lib-Dem votes are often regarded as wasted, like voting for a third candidate in a U.S. presidential election.

As a result, Johnson is betting that he’ll romp home with a decisive majority over a divided Labor party and weakly supported Lib-Dems. So far his judgment has been poor on every big issue. So we’ll see how that turns out for him.

I have close friends on both sides of Brexit, and can well appreciate the emotions supporting leaving the EU even though I would have voted to Remain. I’ll be visiting the UK next week, and have little doubt it will be a topic of discussion.

In any event, I no longer vote in the UK, having emigrated over thirty years ago, thereby forfeiting my UK voting rights. Instead, I vote in the U.S. at every opportunity, including primaries and even school board elections. Brexit is an utterly absorbing spectacle for this transplanted Brit, safely ensconced in the U.S. Those who criticize America’s dysfunctional politics should watch the UK for a few days. Its democratic institutions are proving robust, in spite of the efforts of the current crop of leaders to break them.

EU history is full of late night crisis negotiations that avert catastrophe. Surely the biggest crisis of all will ultimately be resolved this way. My bet is that the UK will leave with a new deal, and as ill-advised as that move is, they’ll muddle through and things will work out. But there’s a wide range of possible outcomes, and next week I may change my mind again.

Clients often want to discuss the correlation between returns on midstream energy infrastructure and crude oil prices. Prior to 2014, investors learned that pipelines were like toll roads, more concerned with the volumes passing through than its value.

The 2014-16 crude oil collapse drove down the energy sector. Alerian’s index shed 58.2% over eighteen months, and the faith was lost. Conventional wisdom became that the pipeline business took a hit with lower oil. The truth was more nuanced – sector EBITDA grew throughout that period even while stock prices sagged (see REITS: Pipeline Dividends Got You Beat). Financing growth projects caused distribution cuts (see It’s the Distributions, Stupid!), alienating income-seeking investors.

Regular readers know the story, which is recounted in the links above.

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Many would regard the chart below as confirming the high correlation between midstream and crude that they know to be the case. In fact, the correlation since the beginning of last year is 0.21, positive but not that meaningful. The nature of the calculation is that brief periods of sharp opposite moves have an outsized effect on the resulting number, compared with what a casual glance at a chart might imply.

The latter half of 2018 was probably one of the most frustrating periods for investors in recent years. Crude oil rallied strongly during the summer, while midstream stocks slumped. In the fall, crude fell sharply as the stocks continued falling. Statistically, the summer’s negative correlation followed by a positive one in the fall resulted no correlation for the entire period. But investors, reasonably enough, recall the period with more feeling than the statistics might suggest.

The answer is that midstream energy infrastructure tends to move with the overall energy sector – not surprising, since the E&P names are its customers. The S&P Energy ETF (XLE) moves with crude, which drives sentiment. Natural gas and associated liquids are more important than oil to pipelines but daily gyrations have little effect.

Questions on how the sector will hold up if interest rates rise are less common. Perhaps investors have tired of worrying about rising rates. Or maybe the sector volatility in recent years has pushed away many income-seeking investors.

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The recent stumble in sectors that had long outperformed (see Momentum Crash Supports Pipeline Sector) coincided with a jump in bond yields. In the first two weeks of September, yields jumped 0.4%. But midstream stocks rallied, since fund flows were dominated by a shift to value and comparative yield spreads mattered little.

We think the attack on Saudi Arabia’s oil infrastructure (see Saturday`s Attack Is A Game Changer) favors U.S. exporters of oil and gas by highlighting the risk of supply disruption out of the Persian Gulf. But putting geopolitics aside, WeWork’s aborted IPO set the negative tone for momentum stocks. Perhaps the correlation that matters is the negative one between unicorns and tangible energy infrastructure.

Early analysis of the twin attacks on Saudi Arabia’s oil infrastructure has focused on the length and severity of supply disruption. 5.7 Million Barrels per Day (MMB/D) of lost output is the biggest supply drop in history, although its impact will depend on how long it takes to repair the damage.

This misses two more important results: (1) the physical vulnerability of Middle Eastern energy infrastructure, and (2) the increasing odds of regional conflict.

The attack laid bare Saudi Arabia’s inability to defend itself or even intercept enemy drones traveling through its airspace. This is an embarrassing failure of the Saudi military to protect the kingdom’s vital infrastructure. Buyers of crude oil will need to consider the ability of suppliers to deliver on their commitments. A substantial portion of the world’s energy comes from unstable regions, and Saturday’s attack showed that it’s possible to create significant disruption by targeting chokepoints in the supply chain (Investors Look Warily at the Persian Gulf).

It’s not just crude oil that’s at risk, although that is the current focus. Qatar is the world’s biggest exporter of Liquified Natural Gas (LNG), sending around 10 Billion Cubic Feet per Day (BCF/D) through the Straits of Hormuz,  25% of the global LNG market. The five biggest export markets are in Asia, where 75% of LNG trade takes place.

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The risk of disruption to LNG and seaborne crude trade is now higher. At the margin this all makes Middle East sourced hydrocarbons more expensive and less reliable. Higher maritime insurance, additional storage in case of supply disruption and all the related risks of doing trade in a region sliding towards open conflict will require market adjustment.

By contrast, the U.S. energy sector is a clear winner. Its infrastructure is geographically dispersed and protected by the world’s military superpower as well as two oceans. The reliability of American supply suddenly seems a bit more important.  Added to that, Canada’s export pipelines  connect to the U.S. providing another reliable 3.5MMB/D of oil supply.

U.S. midstream energy infrastructure also has more global importance, since the growing role of the U.S. as an exporter makes world markets more reliant on a producer able to lift production when needed.

The Permian basin, which accounts for most of U.S production growth, is only expected to add about 0.6 MMB/D over the next year, so won’t suddenly produce an additional 1 MMB/D. Sustained higher prices will assuredly lift output over time, but even short cycle shale has its limitations.  Large multi-pad wells that are the most economic can take up to a year and a half to bring online.

Markets have not really repriced the odds of the regional conflict spreading to include Iran directly rather than its proxies. We have noted before the link between the pre-1941 embargo on Japanese oil imports and the current embargo on Iranian exports. The problem is that the U.S. is not offering the Iranian regime a clear path out. Since open conflict would be disastrous, Iran is pursuing asymmetric conflict with plausible deniability. Moreover, the shift from mining tankers in the Gulf to attacking oil infrastructure is a clear ratcheting up. Whether intentional or not, this seems likely to provoke a response. Saudi Arabia’s rulers must be considering right now the type of military response required and whether they even have the capability to deliver it alone.

Public support in the U.S. for another major conflict in the Middle East is low, and the Shale Revolution affords us more geopolitical flexibility. But if the U.S. does not take a military role, the vacuum will force other countries to consider their willingness to risk further disruption to the 20MMB/D coming out of the region.

Middle Eastern energy supplies are more vulnerable to disruption that previously priced in financial markets (i.e. Brent-WTI spread). U.S. energy infrastructure has an important role to play in providing secure energy supplies. The Middle East is headed towards more open conflict between two big adversaries.

Markets seem to have focused so far only on the short term disruption and how long Saudi Aramco will need to restore supply – currently estimated at a few weeks, although on the weekend it was said to be only days.

We think this attack requires a significant recalibration of supply security. American energy assets look very attractive.

Saturday’s surprise attack on Saudi Arabia’s Abaqaiq oil facility in Buqyaq has sent crude oil prices sharply higher. There are estimates of up to 5.7 Million Barrels per Day (MMB/D) of lost output. For perspective, the last two big drops in crude oil, in 2008 and 2014-16, were caused by around 2% excess supply. The lost Saudi output, half of what that country produces, represents around 5% of world demand.

It’s unclear how long it will take to repair the damage. Estimates are at least several weeks. Saudi Arabia has assured buyers that deliveries will be augmented from crude kept in storage.

Regardless of where crude prices go, owning energy infrastructure in the U.S. looks a bit smarter (see U.S. Insulated From Possible

Landscape image of a oil well pumpjack wiith an early morning golden sunrise and American USA red White and Blue Flag background.

Supply Shock After Saudi Attack). U.S. production is decentralized, making it virtually impossible for a single attack anywhere to disrupt a significant portion of output. And while terrorism remains a relentless threat, the U.S. has shown it is able to protect its vital assets.

Although crude oil prices will initially provide a lift to the perennially downtrodden midstream energy infrastructure sector, we think investors will reassess sources of energy supply based on stability. This should provide more enduring support to a business that is wholly based in North America, far removed from the world’s unstable regions and increasingly the world’s marginal producer.

Much of the world’s energy comes from politically unstable parts of the world (see Investors Look Warily at the Persian Gulf). The Shale Revolution has provided America with more geopolitical flexibility to pursue its aims without worrying about OPEC cutting supplies (see U.S. Plays Its Foreign Policy Hand Freed From Oil). Growing domestic production gives America greater control over its economy (see Shale Security).

Midstream energy infrastructure, which supports American energy independence, is a clear beneficiary of the weekend’s news.

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Breaking News — Drone attack disables Saudi crude ouput

Although we don’t normally highlight the favorable geopolitics of U.S. midstream energy infrastructure, this news does emphasize that much of the world’s crude oil comes from unstable regions. See WSJ story U.S. Insulated From Possible Supply Shock After Saudi Attack

Momentum Crash Supports Pipeline Sector

The action in equity markets last week was beneath the surface. Daily moves in the S&P500 were unremarkable, but a sharp turn in momentum stocks caused lots of churning.

The resulting shift into value was welcome news for energy investors. Momentum and Value had tracked each other reasonably well for the past year until May, when Momentum began to outperform.

Eventually midstream energy infrastructure (defined as the American Energy Independence Index, AEITR), and Value both weakened during the summer. By late August, Momentum had opened up a 14% gap against Value over the prior five months, with similar outperformance against AEITR.

As portfolio managers in the pipeline sector we often struggle to explain the moves in the stocks we own. Apart from earnings season, macroeconomic developments and fund flows dominate. This past period was especially hard to understand because 2Q19 earnings reports were generally as expected.

In September this trend has reversed (see Drop in hot stocks stirs memories of ‘quant quake’), for reasons no clearer than those that preceded it. Value is 8% ahead of Momentum since Labor Day, lifting the AEITR with it.

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What’s behind this? Large pools of capital are deployed based on factor bets like Momentum and Value, relying on research that ascribes long term equity returns to them. Momentum has been outperforming Value for several years – since the peak in oil in 2014, which partly explains negative sentiment towards the energy sector since then.

During the summer, the difference in relative performance jumped sharply, leading to the recent correction. Perhaps slowing global growth has caused a reassessment of high fliers. It increasingly looks as if trade tariffs, which are simply import taxes, are spreading a chill across the world economy.

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Momentum has slipped 9% against Value since August 29. This is an unusually fast correction. In 2016, Value outperformed Momentum by 10%. This lifted MLPs, with the Alerian MLP Index returning 18% that year.

If Value starts to regain favor, investors will find plenty of cheap stocks among midstream energy infrastructure.

Blackstone — Tallgrass

Two weeks ago Blackstone offered to acquire the 56% of Tallgrass Energy (TGE) it didn’t already own. The $19.50 per share price was below the $22.47 at which Blackstone had bought 44% earlier this year. But the sideletter allowing TGE management to sell at $26.25, regardless of the price received by other TGE shareholders, is unethical.

As we noted in Blackstone and Tallgrass Further Discredit the MLP Model, the deal exposed an ethical gulf between the prevailing standards at asset managers and the public companies we invest in. If we treated our investors the way TGE proposes to, our careers would be brief.

What’s surprising is the silence among other TGE investors as well as sell-side analysts. Few wish to risk upsetting either Blackstone or Tallgrass by pointing out the obvious. This failure to speak out is itself a disservice to clients.

Although there have been no further announcements since the proposal was made public, TGE’s stock has edged above the deal price. Some traders are betting that Blackstone will sweeten its offer. If that turns out to be the case, we’ll be happy to have helped.

We are invested in TGE

The end of August was the five year anniversary of the peak in MLPs. Had it not been for the distraction caused last week by a more compelling story (see Blackstone and Tallgrass Further Discredit the MLP Model), we would have already noted this milestone.

The Alerian MLP index, albeit much changed and diminished since August 2014, remains 38% lower including dividends. We won’t repeat the reasons, which are familiar to regular readers (see It’s the Distributions, Stupid!).

Pipeline stocks have certainly labored under some poor management decisions (see Kinder Morgan: Still Paying for Broken Promises) and self-dealing (see Why Energy Transfer Can’t Get Respect). However the Blackstone take-private offer for Tallgrass (TGE) plays out, this unfortunate episode has confirmed the wariness of many investors for the weak governance of publicly traded partnerships.

But the broad energy sector also languishes, now representing less than 4.5% of the S&P500. The S&P energy ETF (XLE) is 42% off its highs of June 2014. The Van Eck oil services ETF (OIH) is down a staggering 83%. The sustained weakness in the pipeline sector has to be considered against this backdrop. Even Exxon Mobil (XOM) is 25% off its April 2014 high, and yields over 5%. For the first time in the history of the S&P500, XOM is not in the top ten.

Energy investors are keenly aware that, although their sector bottomed in February 2016 along with crude oil, the broader equity market has risen over 50% from that low point. The S&P500 is within 2% of new all-time highs.

Holders of midstream energy infrastructure stocks are clearly not momentum investors. But they have identified relative value – the chart below highlights that relative P/Es compared with the S&P500 favor MLPs more clearly than during the financial crisis, or even the February 2016 low which capped an even bigger drop than in 2008-9.

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P/Es rarely even figure in evaluations of MLPs, since earnings are often distorted by depreciation charges that don’t reflect the actual change in value of owned assets. So it’s notable that even using earnings numbers that are usually lower than Distributable Cash Flow (DCF), the sector is cheap.

In discussions with investors, we continue to find that growth in free cash flow is the strongest bullish case. The chart below (also see The Coming Pipeline Cash Gusher) is based on the American Energy Independence Index, which provides broad exposure to North American corporations along with a few large MLPs. Existing assets are generating increased DCF, and investment in new projects peaked last year. We revise these projections quarterly based on guidance during earnings calls, and so far the numbers are approximately tracking what we expected when we first projected FCF in April.

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There can be few areas of investing as unloved as energy. Investors may be put off by past distribution cuts, poor capital allocation decisions, questionable governance or climate change (see  Our Fossil Fuel Future (With a Bit More Solar and Wind)).

In response: distributions are rising; growth capex has peaked; most of the sector is now corporations, with more robust governance; and serious long term forecasts recognize that fossil fuels will provide 80% or so of the world’s energy for decades to come.

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Valuations and growing cashflows support a recovery in prices.

We are invested in TGE.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

​To be an SEC-registered asset manager is to submit to extensive rules of behavior, all with the objective of protecting the clients. Where a portfolio manager invests personally alongside her clients, creating a desirable alignment of interests, regulations require that the client’s interests are placed ahead of the manager’s. The asset manager has a fiduciary obligation to the owners of the capital under management, and a web of regulations exists to this end. CFA charterholders agree to additional obligations regarding ethical behavior and the primacy of clients’ interests.

The recent offer from Blackstone (BX) to acquire the 56% of Tallgrass Energy LP (TGE) it doesn’t already own at $19.50 per share has revealed an ethical gulf between prevailing standards at the providers of capital versus the users. No SEC-registered asset manager could do to its investors what TGE management is doing to theirs.

When BX acquired 44% of TGE in January at $22.43, a regulatory filing of a sideletter outlined an unusual arrangement under which, if BX bought the rest of TGE within a year, TGE management could sell their shares at $26.25.

In April, TGE CEO David Dehaemers fielded questions as to whether this arrangement created a risk that BX might take advantage of weakness in TGE shares to buy the rest of the company cheaply. He was adamant that, “…there is no intention of Blackstone doing anything here untoward.” Dehaemers went on to note that, “I’ve still got $50 million and invested in that. And that is from money that I put in this thing. It’s not restricted stock in fact I’ve never gotten a share of restricted stock in the last seven years at this thing.

“And so I didn’t leave $50 million in this thing to lose money and that just simply [isn’t] going to happen.”

These comments led investors in TGE to erroneously believe that they were invested in TGE alongside Dehaemers.

TGE’s stock fell sharply in August, creating the conditions for BX to acquire the rest of the company. Perversely, the weaker TGE’s stock the more likely was BX to attempt the buyout. Since the buyout triggered the $26.25 sale price, Dehaemers and other senior management actually benefited from the stock falling.

Although the $19.50 “take private” offer was 36% above its price the day before, it was below where TGE had traded all year until the sharp drop in August.

One might initially regard the elevated price for management’s TGE shares as nothing more than a bonus for selling the company. But because the $26.25 price is independent of the price at which the company is sold, the sideletter breaks the alignment of interests that exists when management owns shares alongside investors. The price received by other TGE investors no longer impacts the management team’s economics.

Nobody has suggested TGE deliberately drove their stock lower. But management clearly had little incentive to arrest the decline. Questions on capex plans and recontracting of pipelines received frustratingly vague answers. A management team incented to drive the stock price up might have been more forthcoming. Clearly BX, as an insider, saw little to concern them in the company’s recent operating performance.

We’ve long liked David Dehaemers and what he has achieved at TGE. We’ve talked to him several times in the past. But we are deeply disappointed at this turn of events, which at best reflects a serious judgment lapse on his part.

TGE is a partnership, which means it has much weaker governance than if it was a corporation. Sideletters such as this are legal, whereas it’s hard to imagine such a device being employed if TGE was a regular c-corp. It seems that investors in partnerships cannot rely on management promises that they have “skin in the game”, and that shared outcomes are assured.

The energy sector already struggles to demonstrate responsible stewardship of capital. The weak corporate governance of MLPs has dissuaded many institutions from investing in them. Some, like TGE, have elected to “check the box” so as to be taxed like a corporation while retaining the partnership structure. Although this improves tax reporting by providing holders with a 1099 rather than the disliked K-1, the governance weaknesses remain.

The BX-TGE episode will tarnish all the partnerships that remain in midstream energy infrastructure. Investors have little reason to hope for a high-priced acquisition, since it seems management can negotiate a different price for themselves. What’s to stop Kelcy Warren selling control of Energy Transfer (ET) in exchange for the acquisition of just the management team’s shares at a substantial premium to what’s offered the other investors? It seems there’s very little, which alters the risk/return profile.

Partnerships trade at a discount, and this shows why.

In a podcast interview with Alerian’s Kenny Feng last year, Dehaemers recounted a time earlier in his career when he wanted to relocate his family back to Kansas City, so his two boys could attend a Jesuit school. So he must know as well as anyone that unethical behavior isn’t excused simply by pointing to its prior disclosure, as is the defence of the BX-TGE sideletter.

It shouldn’t be the case that the asset managers who invest in companies like TGE adhere to higher ethical standards than the companies do themselves, but that is how things work. The list of publicly traded partnerships that can be relied upon to refrain from such moves is a short one. Choosing to pay corporate taxes while retaining the partnership structure can only be justified by managements that desire the weaker protections afforded investors, compared with corporations.

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Rich Kinder did much to build the MLP model with Kinder Morgan (KMI) before breaking his “promises made, promises kept” pledge on distributions (see Kinder Morgan: Still Paying for Broken Promises). Five years later, income seeking investors have still not forgotten. David Dehaemers worked under Kinder at KMI, who was at Enron before that. A substantial portion of America’s energy infrastructure emerged from Enron’s energy business. Jeff Skilling’s record of broken promises persists.

TGE’s board has an opportunity to restore some trust, depending on how they respond to BX’s offer.

We are invested in ET, KMI and TGE

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Last week the Financial Times wrote about the dwindling conviction of believers in the Shale Revolution (see Why US energy investors are experiencing a crisis of faith). Religion is an appropriate metaphor – secular values such as Enterprise Value to EBITDA or forward free cash flow yield have offered scant protection. To invest in energy today is to be a Christian thrown into Rome’s Coliseum.

In January Blackstone Infrastructure Partners (BIP), invested $3.3BN for a controlling interest in Tallgrass Energy (TGE) which, following a simplification of its GP/MLP structure left Blackstone owning 44% of the company. On Tuesday night TGE disclosed a take-private offer from BIP for the rest of TGE. It’s a measure of how poorly TGE’s stock has performed that buying the remaining 56% would cost $200MM less than BIP’s original investment even after the 35% premium embedded in the proposal.

The good news came with a sour taste. A previously agreed sideletter between BIP and TGE came to light revealing a sweetheart deal for management. In the event of a take-private transaction like this one, management can sell its shares at $26.25, not the $19.50 agreed for all the public investors. A cynic might conclude that TGE allowed uncertainty about their capex plans and recontracting on pipelines to weigh on the stock price, inviting BIP to acquire the balance below their earlier deal price while paying insiders 35% more. Energy sector executives provide ample material for critics who see scant evidence of a fiduciary mindset.

Returning to negative sentiment, retail investors struggle with the failure of growing oil and gas production to lift the prices of midstream energy infrastructure, with its toll-model supposedly fairly insulated from commodity prices. Public market valuations differ from where private equity sees things. It turns out  BIP is also puzzled but happy to exploit the opportunity.

They’re not the only private equity investor to have misjudged the depth of public market antipathy to energy. Last year Global Infrastructure Partners (GIP) invested $3.125BN to acquire a controlling interest in Enlink Midstream (ENLC). Following their GP/MLP simplification a few months later, GIP owned 40% of ENLC.

Today ENLC’s market cap has sunk to $3.6BN, creating a paper loss for GIP of almost $1.7BN. Former CEO Barry Davis returned, replacing Mike Garberding who had been promoted from CFO less than a year earlier. It’s not just retail investors who have bought into undervalued pipeline stocks too soon.

Earlier this year private equity firm IFM Investors bought Buckeye Partners for $6.5BN, a 32% premium to the market price.

Goldman Sachs recently noted that around $250BN in private equity “dry powder” is dedicated to infrastructure and natural resources. It won’t all find its way into the U.S. pipeline sector, but the American Energy Independence Index, which broadly reflects the sector, now has a market cap of around $450BN. The float-adjusted figure, removing shares held by management that don’t trade, is $372BN. GIP is raising a fourth fund targeting $17.5BN, undeterred by the paper loss GIP III has taken on ENLC.

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The end of August marked the five year anniversary of the peak in the Alerian MLP Index. It remains 39% off its high. Hinds Howard, who follows the sector for CBRE Clarion Securities, notes more than 80 constituents have been removed from the index. MLPs have steadily become less representative of midstream energy infrastructure. The Alerian MLP Index (AMZ) has a market cap of around $250BN ($150BN float-adjusted).

The FT article blamed the slump in part on poor spending discipline. By way of confirmation, PDC Energy’s (PDCE) recently announced acquisition of SRC Energy (SRCI) anticipates annual savings of $50MM in General and Administrative (G&A) expense. Considering SRC’s entire G&A was $39MM last year and the company’s market cap is $1.1BN, this is not a company with a parsimonious culture towards corporate overhead. Both stocks rose on the news.

Investors want further consolidation in the energy sector, including midstream. There are more senior energy executives than we need.

We are invested in ENLC and TGE.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Yields on McDonalds’ Euro-denominated bonds recently joined European sovereign debt in negative territory. It’s a headline writers dream (juicy burgers, not yields…customers and investors pay to do business, etc).

$17TN in publicly traded debt now yields less than zero – 30% of the entire investment grade market. Debates rage about what this means. Bond investors are not accused of being analytically weak – something bad must be over the horizon. As mentioned before, we’re contemplating the idea that such a stubborn retention of fixed income investments reflects a degree of risk aversion towards stocks, for fear of a sharp fall. The searing memories of the financial crisis are within the careers of most market participants. Stocks are always vulnerable to a big sell off. But the preponderance of caution reflected in the scramble for low-risk yet yield-less bonds suggests speculative fever is not rampant. In this view, stocks are cheap.

The energy sector has provided unattractive risk/return of late. It’s why it’s so cheap. One of the reasons for poor sentiment could be climate change. 82% of the world’s energy comes from fossil fuels, and the average of serious 20-year forecasts sees this at around 80% in 2040. Reading articles on renewables can consume much of a day, every day, while those expecting the 82% share to stay roughly the same are a rare breed.

If equity valuations on midstream energy infrastructure stocks reflect a widespread belief that oil and gas pipelines will soon be as useful as a VHS recorder, bonds issued by these same companies should offer commensurately high yields.

But they don’t. A review of yields on the investment grade bonds of U.S. issuers in the American Energy Independence Index averages 3.7% (using the weights of the index). Although yields of any kind are hard to obtain nowadays, the 3.9% yield on 2054 bonds issued by Enterprise Products Partners (EPD) suggests a high expectation of being repaid in full. This in turn requires pipelines and related infrastructure to maintain their critical role in America’s energy supply for at least another four decades. EPD’s stock yields over 6%. Its distribution is growing and buybacks are likely. Try and conceive a scenario in which the holder of the 2054 bonds will, over any plausible investment horizon, do better than the equity investor.

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Kinder Morgan (KMI) has bonds maturing in 2098, in effect perpetual debt, yielding 5.1%. Although this is modestly higher than the stock’s 4.9% dividend yield, next year’s expected 25% hike will fix that. Although the 2098 bond issue is a tiny $26MM, they have $33BN outstanding, much falling due after 2040. The holders of KMI 2098 bonds no doubt congratulate themselves for doing better than investing in French energy giant Total (TOT), who recently issued perpetual Euro debt at 1.75% (see Blinded by the Bonds). But if they like KMI’s 80 year bonds, they’d have to prefer the equity.

The investment grade issuers in the table represent half of the American Energy Independence Index. Their long dated bonds yield 4.3% — profligate by today’s standards, but nonetheless too low to reflect anything other than confidence of full repayment over the decades ahead. The holders of these bonds must regard equity buyers as having abandoned all reason in allowing dividend yields to drift so high.

If fixed income buyers like midstream energy infrastructure, eventually equity buyers will find reason to follow.

We are invested in EPD and KMI.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).