Californians have recently been enduring rotating blackouts – short term loss of power due to excessive demand. When the lights go out and the a/c units no longer hum, it’s always political. Oddly, both sides can agree that climate change is to blame. Liberals attribute the extended high temperatures in southern California to the gradual manmade warming that is afflicting the planet. Conservatives see a reliance on unreliable renewables as the cause – underlying the power supply shortfall was the loss of 100MW of output from a wind farm.

Perhaps global warming is making it less windy. Environmental extremists will argue that fighting climate change is ever more urgent, while pragmatists will note that using more intermittent renewables is leaving consumers vulnerable to shortages.

What’s happening in California is important to all Americans, because it’s a preview of what an energy policy run by environmental extremists could look like if inflicted across the entire country.

For the past decade, California has been steadily pushing renewables’ share of power generation. For much of that time natural gas was easily the biggest source of electricity, since coal use stopped completely in 2015.

But environmental extremists have been single-minded in their desire to run everything with solar panels and windmills. Although the state has not banned natural gas, it does allow cities and counties within the state to do so. Diablo Canyon, California’s last remaining nuclear power plant, will close its two reactors in 2024-25.

In 2018, California passed a law mandating 50% of its electricity to be from renewable sources by 2025, 60% by 2030 and 100% by 2045. There are no plans to build new nuclear capacity, so it looks like sun and wind will be the major source of power.

America has been reducing its CO2 emissions, but oddly California has been lagging the rest of the country, with a slight worsening since 2011. This fact must sit uncomfortably with those thoughtful advocates of California as a leader in renewables. The problem, as anyone trying to drive around Los Angeles knows, is that transportation still relies heavily on fossil fuels. A couple of years ago when I was visiting clients with a salesperson for a couple of days, traffic estimates were critical to our meeting schedule. In fact, every meeting seemed to open with a brief chat about the 405. Automobiles and traffic jams generate a lot of California’s emissions.

California’s renewables effort has focused on electricity, but that’s less than 14% of total energy consumption. This is why the popular image of green California isn’t reflected in reduced emissions.

The average retail price of electricity in California is 16.58 cents, versus 10.53 cents for the country as a whole. Unreliable power that costs 57% more than the average, along with a slower rate of emissions reduction, are not the hallmarks of a successful policy to combat climate change. This is where the drivers of Joe Biden’s energy policy are hoping to take us. The Biden-Sanders Unity Task Force has recommended, “…eliminating carbon pollution from power plants by 2035”. This is a decade ahead of California – because it’s going so well there.

California’s power blackouts are in part because the wind has inconveniently not been blowing when needed. This is why natural gas is such a good compliment to intermittent renewables – it’s always available. Many other U.S. states have embraced this, including Nextera (NEE), loved by environmentalists and investing in natural gas pipelines.

Energy density is another challenge that will lead to NIMBY problems.

An article in the Financial Times (see Green power needs to be dense power) compared the 950 acres required for a UK solar farm to produce 350 megawatts of power with the 80 acres to house a nuclear project with 3,200MW of output. Not only is this 9X the power output on under 9% of the land, but the solar plant is only expected to operate at 11% capacity, versus 90% for the nuclear. The power output per acre is 1,000 times lower for this solar installation compared with nuclear, a significant problem in densely populated Britain.

Any solar installation in the UK is a green extremist triumph in willful denial of the climate – but at least they’re still building nuclear plants, because they do want to keep the lights on.

California’s blackouts show what happens when climate extremists run energy policy. The silver lining for investors is that such policies lead to, and desire, high energy prices – both as a constraint on demand and also because it makes renewables less uncompetitive. Returns on energy investments tend to follow energy prices. Green policies that constrain supply need not be bad for the sector.

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

Investors often ask, what will it take to get pipeline stocks moving upwards? Attractive valuations and the prospect of higher cashflows are compelling, but when will investors start acting?

They may already being doing so. Kinder Morgan kicked off earnings after the close on July 23^rd. Since then, results for the sector have generally come in as expected, with more positive surprises than negative. The encouraging free cash flow outlook remains intact (see Pipeline Cash Flows Will Still Double This Year). The most positive among the big companies was Williams Companies (WMB), whose earnings scarcely showed any impact of the pandemic (see Williams Has Covid Immunity). Their gathering and processing business held up better than volumes across the country, and WMB took another $100MM off their 2020 growth capex which further cheered investors. WMB was up 8% following the announcement.

The two big Canadians, Enbridge (ENB) and TC Energy (TRP) were both resilient. ENB even added $100MM to their growth capex plans – they’re probably the only company that could do so without seeing their stock sell off. TRP has one of the bigger capex budgets, mostly driven by the perennially delayed Keystone XL. Joe Biden has committed to withhold the required Federal approval of this cross-border project, reflecting a leftward shift in his platform. If he wins the election, Canadian oil producers will suffer but investors in TRP will likely benefit from higher free cash flow without the Keystone spending.

Cheniere Energy (CEI) reported $405MM of cargo cancellation revenues. Cheniere has always maintained that their 100% investment grade customer base and very long term contracts insulated the company from fluctuating volumes. Falling demand for shipments of Liquified Natural Gas (LNG) caused some weakness in CEI earlier in the quarter. The $405MM represents some tangible evidence of the security of the contracts. Typically, when a buyer cancels a contract CEI takes ownership of the LNG shipment and is free to find a new buyer.

Energy Transfer (ET) remains one of the cheapest big pipeline companies – their eye-popping 17% yield is in part because of CEO Kelcy Warren’s opportunistic ethical lapses (see Energy Transfer’s Weak Governance Costs Them). Questions remain around their elevated leverage, which is still above 5X. Some analysts would like to see them cut their distribution so as to delever faster. The company believes they can rely on growing EBITDA, although CFO Tom Long did say, “…the distributions are a topic when we discuss how to get the leverage down.” So that 17% yield isn’t secure.

Oneok (OKE) saw weaker than expected gathering and processing results, and they revised full year EBITA guidance to the low end of the range so they see continuing softness.

We thought Plains All American (PAGP), which is all crude oil, should have done better in their Supply and Logistics (S&L) segment. The dislocation in April was manifested by the negative price for front month of futures. This should have been a perfect environment to own storage assets in multiple locations and the pipes to connect them. Disappointingly, PAGP’s S&L segment adjusted EBITDA came in at only $3MM, and is running at $144MM for the first half of the year. During 1H19 they did $478MM. Management has done a good job at lowering analyst expectations for this business. Enterprise Products Partners’ (EPD) Marketing segment turned storae and contango opportunities into $185MM in 2Q20. PAGP should be aiming higher.

Overall, midstream energy infrastructure earnings were good, and with dividend yields still above 8% it is poised to move higher.

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

Pipeline company earnings continue to provide reassurance about their ability to grow cash flows (see Pipeline Cash Flows Will Still Double This Year). Yesterday’s earnings call with Williams Companies (WMB) was an example.  

WMB’s 2Q adjusted EBITDA came in at $1,240MM, $48MM ahead of expectations. For the full year they are guiding conservatively to the low end of their prior range ($4.95BN-$5.25BN). 2020 growth capex was reduced by another $100MM to $1BN-$1.2BN. Like other pipeline companies, WMB’s continued trimming of growth capex is boosting their cash flow generation (see Pipeline Opponents Help Free Cash Flow).

Leverage has now come down to 4.31X Debt:EBITDA. Their $1.60 annual dividend still yields 7.5%, even after yesterday’s 8% rally in the stock. 

WMB is among the best positioned pipeline companies – almost 100% natural gas. Its gas transmission business, which is 44% of EBITDA,  is two thirds utilities and 90% investment grade. Gathering and processing, which is the rest of the company, has picked its customers well, growing 3.6% year-on-year even while Lower-48 production is roughly flat.

CEO Alan Armstrong noted what we’ve pointed out recently, that natural gas demand has remained strong and shows little impact from the pandemic (see Energy Demand After Covid-19). Armstrong also mentioned that canceled LNG shipments, the only area of weakness, appear to be moderating in July.  

Armstrong spoke to the complimentary relationship gas-fired power generation has with solar and wind. Pairing always-available gas with intermittent renewables allows for increased use of both and lowers overall CO2 emissions. Since natural gas is crucial to any serious green initiative, WMB has a secure future (see Where America gets Its Power). 

Transco, WMB’s extensive natural gas pipeline network that runs from Texas to NY, sits beneath many dense population centers. Given today’s uncertain regulatory process faced by new projects and successful opposition from environmental extremists (see Installed Pipelines Are Worth More), Armstrong feels that WMB’s extensive existing infrastructure gives them an advantage in expanding to meet growing demand. It’s much less disruptove to add on to an existing network than to embark on a new, greenfield project.

WMB’s business was neither helped nor hurt by Covid. In that respect it offers more visibility, if less excitement, than some of today’s high-fliers that are profiting from the new stay-at-home lifestyle. In effect, WMB is immune to Covid. It looks like a pretty cheap stock.

On a different topic, the owner of Jos A. Banks, Tailored Brands, recently filed for bankruptcy. I have followed Jos A. Banks with interest ever since 2008 when I saw Marc Cohodes, a short seller, explain why “Buy One Get Two Free” was not a sustainable business model for selling mens suits. I recounted this in The Hedge Fund Mirage. Cohodes had a tragically bad financial crisis for a short seller and for a time left Finance in disgust (see A Hedge Fund Manager Finds More to Like in Farming). On Jos A. Banks, Marc was early but ultimately right.

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

In February, following our criticism of Kinder Morgan’s (KMI) return on invested capital (see Kinder Morgan’s Slick Numeracy) the company, to their credit, reached out to us so as to better present their perspective. Our point was that capital allocation decisions in recent years had not always been accretive to equity. We offered the company an opportunity to write a rebuttal which we promised to publish, unedited, but they declined. So we summarized their response (see Kinder Morgan Responds to our Recent Criticism).

Not long after, Covid dominated the news, and historic returns on invested capital took a backseat to gauging current demand destruction. KMI’s stock sank from $21 to under $10, before recovering roughly halfway to $14.

KMI kicked off earnings reports for the sector last week. We were most interested in their outlook, but also in their planned growth capex. Industry-wide spending reductions are driving improved profitability (see Pipeline Cash Flows Will Still Double This Year).

KMI announced a $1BN goodwill writedown on natural gas gathering and processing assets previously acquired. Although a non-cash expense, this is an example of capital deployed whose cash generation will no longer meet its target. KMI will blame Covid, but nonetheless it’s a loss for shareholders.

The company confirmed guidance of $1.7BN in “expansion opportunities” (we winced) for 2020. This is well below their prior range of $2-3BN annually over the next decade, as initially communicated in April during the depths of lost production. Several questions followed on the earnings call – in response to Shneur Gershuni of UBS,  CEO Steve Kean allowed that future capex, “looks like it hangs around the level we’re seeing in 2020, maybe a little less.”

This cheered us, and later JPMorgan’s Jeremy Tonet asked, “…is there a scenario where 2021, or maybe in 2022, where growth CapEx could be as low as $1 billion?” We were left positively giddy when Steve Kean replied, “We’re close, yes. We’re close.”

When it comes to pipeline company growth capex plans, they share the qualities of an overly vigorous golf swing – less is more.

KMI’s adjusted EBITDA came in at $1,568MM versus expectations of $1,634MM. They also lowered full year DCF to 11% below budget (was previously 10% below). They still plan to increase their dividend to  $1.25 annually, which would yield over 8.5% at the current stock price. They expect to reach 4.5X Debt/EBITDA although conceded 4.7X is their likely year-end level.  They also pushed back the date at which they expect to be a corporate taxpayer to 2026.

Meanwhile, domestic production is recovering along with demand. In recent weeks, oil production has risen from 9.7 Million Barrels per Day (MMB/D) to 10.9 MMB/D, and the industry now expects it to settle in around 11 MMB/D. That’s still well below the pre-Covid level, which was on track to hit 13 MMB/D by year’s end. But it’s improving. “It’s a slow, slow recovery, but it’s happening,” said Alexandre Ramos-Peon, a senior analyst at Rystad Energy, a consultancy.

Natural gas demand of 85.5 Billion Cubic Feet per Day (BCF/D) remains close to a year ago of 89.4 BCF/D, exhibiting very little response to Covid. LNG exports of 3.7BCF/D are down by 2.4 BCF/D, representing more than half the drop as global LNG demand has softened somewhat. Overall, the market hasn’t registered much impact.

Pipeline stocks such as KMI have dividend yields that reflect considerable market skepticism regarding their longevity. Bond investors harbor few doubts, as we noted recently in comparing Enterprise Products Partners 30 year debt yields of around 3% with the almost 10% dividend yield (see Pipelines Are Becoming Less Risky). KMI just announced a 2050 maturity with a 3.25% coupon. The chasm between dividends and bond yields in this sector reflect rigid investor segmentation, and a misallocation of capital by fixed income buyers who would greatly benefit from the flexibility to incorporate some equity risk.

Earnings reports from other big pipeline companies over the next few weeks should provide confirmation of growing free cash flow and secure dividends.

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

Earnings season for pipeline stocks begins on Wednesday 22^nd, with Kinder Morgan (KMI) reporting after the market close. We expect the quarterly updates from the sector’s biggest companies will confirm the progress towards improved profitability (see Pipeline Cash Flows Will Still Double This Year). We’ll also hear from management teams how they regard the prospects for new projects.

Last year, a stand-off over Kinder Morgan Canada’s proposed Trans-Mountain Expansion halted construction. Opposition from environmental extremists in British Columbia thwarted oil-rich Alberta’s goal of increasing its access to export markets. The Canadian government bought the pipeline, saving KMI from a costly, intractable problem between two Canadian provinces. Enbridge commented in a call that they wouldn’t attempt to build a new oil pipeline in Canada, unless it was wholly within energy-friendly Alberta (see Canada Looks North to Export its Oil).

Following the cancelation of the Atlantic Coast Pipeline (see Pipeline Opponents Help Free Cash Flow), the continued legal uncertainty over already completed Dakota Access Pipeline (listen to  Judicial Over-Reach on the Dakota Access Pipeline) and the perennially delayed Keystone XL, big projects look similarly stymied in the U.S. Given the trends in election opinion polls and economic uncertainty over Covid, we expect few new initiatives for the balance of the year and possibly some further cancelations.

Although management teams will be frustrated, long-time investors in pipelines are realizing that poorly informed yet effective environmental extremists are an unlikely ally in leaving the sector with few options for its excess cash beyond returning it to investors through dividend hikes and buybacks. We expect this theme to play out over a couple of years. We suspect Berkshire’s interest in acquiring Dominion’s natural gas pipeline network is to redeploy the cash it generates to other Berkshire subsidiaries where capex is not controversial.

Investors continue to withdraw money from MLP-dedicated open-end funds. JPMorgan recently reported that during the first half of this year such outflows totaled $764MM, with June marking the fifth straight months of redemptions.

This is clear from relative performance, which shows the Alerian MLP Infrastructure Index (AMZIX) down 33% so far this year, lagging by 10% the more broadly representative American Energy Independence Index (AEITR). Corporations, which dominate the AEITR, have more numerous buyers than MLPs, which is why AMZIX is slumping. A broader set of investors and better governance are widely regarded as favoring corporations. Investor behavior is confirming this trend, which we expect to continue.

Stocks and bonds have appeared to reflect wildly different economic forecasts for years, which is why stocks always look cheap. The contrast between fixed income and equity investments is most dramatic in pipelines (see Pipeline Bond Investors Are More Bullish Than Equity Buyers). To cite one example, Enterprise Products Partners (EPD) has several 30-year maturity bond issues outstanding with yields from 3-3.2%. The company is a third owned by insiders, never cut its distribution and pays a 9.8% dividend. Skeptics of its equity might benefit from chatting with a few EPD bond holders.

We are invested in EPD and KMI, and all the holdings of the American Energy Independence Index via the ETF that tracks it.