Last week Enbridge (ENB) and Enterprise Products (EPD), North America’s two biggest pipeline companies, were among those reporting earnings. Both beat expectations – ENB reported 2Q EBITDA of $3,312MM versus $3,155MM, helped by strong results in natural gas transmission. EPD came in at $1,961MM versus $1,877MM, boosted by strength in crude oil. Dividend yields of 7.7% (ENB) and 10.1% (EPD) look secure.

The earnings calls that accompany quarterly results often provide some interesting additions. The ENB call included several exchanges with analysts on renewables. For example, CEO Al Monaco noted, “…we know the supply profile is going to change globally for energy. It’s not going to be a quick transition by any stretch, but slowly renewables will be a bigger portion.” He continued, “U.S. offshore wind is certainly an attractive opportunity but… the supply chains are not as developed yet”

Bill Yardley, President of Gas Transmission & Midstream, added,“…on the ISO website… wind is 30 megawatts, natural gas is 10,200. You could quadruple the amount of wind as they’re projecting and it’s just–on the peak hours, it’s just not there.”

Although ENB expects renewables to gain market share, conventional fuels still get most of their spending on new projects. Al Monaco explained, “In terms of the asset mix today, I think when we repositioned the asset mix to almost 50/50, I’m going to call it, between natural gas and the liquids businesses, with a little bit in there for renewables, I think we’re happy with the mix there.”

Hydrogen as a potential renewable fuel has been drawing a lot of interest recently. For example, on Nextera’s (NEE) call, hydrogen appears 25 times in the transcript. But it’s still way off in the future.  Rebecca Kujawa, CFO, noted that NEE is, “really excited about hydrogen, particularly in the 2030 and beyond time frame”

On the same topic, ENB’s Bill Yardley added, “Natural gas pipeline networks may be repurposed for hydrogen at some point in the future, if the economics work. To that end, It’s extremely expensive – you know, is it green hydrogen, is it blue hydrogen, how does it interact with the pipelines and the actual steel in the pipeline, and that takes a lot of engineering to look at. But you’re right – the network, and this is decades from now, would be well positioned if hydrogen transitioned from that shiny object that is potentially a solution to a reality.”

EPD’s CEO Jim Teague often adds some colorful phrases and humor to these calls. He referred to the prior quarter’s conference call as a “COVID call” and opened last week by saying, “…today, we are going to tell you our COVID story.”

Since EPD had beaten expectations during a tumultuous period in energy markets, Teague immediately addressed the issue: “We usually get the question of how much of our results are non-recurring, and it is the same question we got when Katrina blew through South Louisiana and literally knocked out every plant we had…Demand came back before indigenous supply and we made more money with our West to East pipelines than if those plants had been running. So it was non-recurring.

“We got that question during Hurricane Ike in 2008… got the question in Hurricane Harvey in 2017.” Teague continued,” Events like what we are going through now, and the opportunities they present may be labeled as non-recurring, but our performance and our results are recurring regardless of the environment.” In other words, the diversity and naturally offsetting risks among business lines create the opportunity for recurring upside surprise.

Crude oil dominates sentiment around pipelines, although natural gas is more important. Little attention is paid to the non-energy side of the business, such as plastics. Teague reminded listeners that,“…the United States, especially in ethylene, has quickly moved into being the world’s incremental supplier.” He added, “In June, we loaded a record size ethylene cargo of 44 million pounds.”

Growth capex is also falling as both companies are maintaining strict return criteria. Teague said, “For 2021 and 2022, we currently anticipate growth capital investments to be approximately $2.3 billion and $1 billion respectively. This is an aggregate $700 million reduction from guidance we provided for 2021 and 2022, at the end of the first quarter.” Last year EPD spent $4BN. Their Free Cash Flow in 2022 is on track to have doubled in only three years.

Both companies can issue ten year debt “with a two handle”, reflecting the confidence of bond investors  in their balance sheets and showing a  juxtaposition with their dividend yields.

Earnings continue to support our expectation of strong cash generation (see Pipeline Cash Flows Will Still Double This Year). Listening to conference calls like these provides further comfort around the outlook.

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

Before the Shale Revolution, midstream energy infrastructure was a boringly stable sector. MLPs, which predominated versus corporations back then, paid out most of the cash they generated and grew distributions through price escalators and improved operating efficiencies. Volatility was low, and attractive yields drew income-seeking investors. This happy marriage started to fall apart in 2015, when the industry embraced the same growth ethos that drove their upstream customers. Leverage and volatility rose, causing distribution cuts and the older, wealthy K-1 tolerant American investor started to leave (see AMLP’s Shrinking Investor Base).

In conversations with investors, the subject of volatility often comes up. Yields are attractive – the broad-based American Energy Independence Index, AEITR yields 9.3% on a trailing basis. Few cuts in payouts are likely as companies report 2Q earnings. Kinder Morgan (KMI) maintained their dividend in Wednesday’s release. Some had been questioning whether Oneok (OKE) would maintain their dividend, but they reaffirmed it on Thursday, yielding 13.4%. Legal uncertainty remains around whether the Dakota Access Pipeline (DAPL) has a secure future (listen to Judicial Over-Reach on the Dakota Access Pipeline). Phillips 66 Partners, LP (PSXP) is most exposed, but they’re only 0.6% of the AEITR. Although Energy Transfer built DAPL and retains 36% ownership, it’s only 3.5% of their EBITDA.

In summary, payment of today’s attractively high payouts is likely to continue. Investors are trying to assess whether they’ll need to endure further downside volatility while clipping coupons.

Relative to the overall market, the movements of today’s pipeline sector are more pronounced but still well short of the 2015 collapse, when energy sector weakness didn’t spill over into the S&P500. Early this year saw the biggest fall in AEITR’s history, but the panic over Covid drove the S&P500 down in the first quarter too, as indiscriminate selling was widespread. Although pipelines have rebounded strongly since then, the AEITR remains down 27% for the year – 10% ahead of the MLP-heavy Alerian Index, but still well short of matching the market, which is in positive territory.

There are three reasons to think that more stability lies ahead for the sector. First, spending on new projects peaked in 2018, and the pandemic has caused every company to further reassess plans for 2020. The result is that pipelines will generate twice as much cash as they did last year (see Pipeline Cash Flows Will Still Double This Year).

Second, closed end funds, whose selling in March exacerbated an already extremely weak sector, have lost much of their ability to repeat this performance. This is because heavy losses destroyed much of their asset base, a development welcomed by all except those unfortunate enough to have assumed the fund managers practiced any responsible oversight of their leverage (see The Virus Infecting MLPs).

Third and perhaps most importantly, pipeline companies are reducing leverage. These slides from recent investor presentations by Enterprise Products, Kinder Morgan and Williams Companies are reflective of what’s happening across the industry. Stronger balance sheets will reassure rating agencies and investors that sharply rising free cash flow is sustainable.

These are all reasons to believe that tomorrow’s pipeline industry will return to the lower volatility and higher returns of 5-10 years ago.

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

The recent news on Covid-19 has been mostly bad. Infections are increasing sharply in sunbelt states, where Florida now holds the record for two worst days’ new infections – 15,300 and 13,965, both reached last week. Reopening plans are being halted. Even the Republican convention scheduled for late August, which was moved from Charlotte, NC to Jacksonville, FL (i.e. from a Democrat governor to a Republican one), has been scaling back its planned attendance.

We’ve aimed to be apolitical in covering what is the biggest story concerning investors nowadays (see Taking The Politics Out Of Covid-19). Writing about this is a fraught subject – you don’t want to get Covid-19, and there have been over 140,000 deaths each one of which is a tragic loss. It continues to be a traumatic time for the country. My mother is high risk, in assisted living, and our interactions with her are constrained in both frequency and form.

Nonetheless, we focus on the data, which we interpret as more optimistic than the media coverage for the overall population. Some readers have criticized us for this. Equity markets clearly have a more sanguine view (see Is Being Bullish Socially Acceptable?), and investors may be wrong or they may collectively also be interpreting the data as more positive. We think it’s worth trying to understand the implied relative optimism, as it contrasts so strongly with how many of us feel.

With that preamble, let me introduce a fascinating table that Kyle Lamb has recently posted on Twitter analyzing Covid-19 fatalities. Some effort is required to fully appreciate the depth of information it contains – we’ll explain:

The Center for Disease Control (CDC) publishes a Provisional Death Count which tracks “deaths involving Covid-19”. CDC data relies on death certificates being processed, so lags by several weeks the data published by the Covid Tracking Project (CTP), which is what most media outlets use. Although both produce weekly data, the CDC updates prior weeks for a couple of months, as they receive new information.

For example, reading off the table for the week ending April 4, CTP shows 6,962. The CDC data shows 9,909, a figure they’ve been revising up every week. The first time they reported a figure for April 4 was on April 11, and it was 2,602. If you sum all the colored cells horizontally, you get the fatality total for the week in the “When Died” column.

If you sum the colored cells vertically, you get what the CDC revisions to prior weeks totaled.

Both have revised their websites to higher figures since the table was produced.

What the table does is break down the CDC fatalities for any given week into multiple weekly buckets to show when they were reported. So the red cells show the CDC’s initial estimate of fatalities for that week. Moving to the right, the orange cells show the number of additional fatalities added to that week’s total a week later.

So what’s the point? Although the CDC’s initial weekly estimate is always revised up, after eight weeks they have most of the data. Within the first two weeks, they typically have 50-60% of the ultimate total for that week.

On April 18, the CDC reported 4,811 deaths for the prior week, a figure that eventually rose to 16,014. The most recent week on the table, ending July 18, shows 272 for the prior week (more recently revised up to 1,099 on the CDC website, which could mean faster reporting or increased fatalities). As the CDC’s initial weekly estimates are falling, it’s reasonable to assume that the ultimate figures will also fall. Clearly sunbelt states are seeing increases, but today’s infected patients are faring much better. They’re younger and are benefitting from improved treatments. Nursing homes have learned to better protect their highly vulnerable residents. CTP fatalities remain well under half the levels of April, when New York was the epicenter.

Stocks continue to trend higher. You should still wear a mask, practice social distancing and wash your hands frequently, as we do. But we’re getting through this.

Several major pipeline developments last week might well represent a key turning point in how the industry operates.

Berkshire Hathaway (BRK) acquired Dominion Energy’s natural gas pipeline and storage assets for an enterprise value of $9.7BN, which included BRK using $4BN of its cash pile. Although some estimated the price on the low side, Buffett clearly sees a long positive future for natural gas pipelines. This was a welcome endorsement.

At the same time, Dominion and Duke Energy canceled their planned Atlantic Coast gas pipeline project (ACP). This has been the subject of numerous court challenges from environmental extremists. The project appeared to be proceeding, with capacity 90% subscribed, and legal challenges successfully rebuffed. However, the possibility of further court proceedings with additional ongoing delays and cost uncertainty led Dominion and Duke to abandon the effort.

In other news, the U.S. Supreme Court over-ruled a lower court, which had blocked a permit program that several pipeline projects were relying on for construction. But at the same time, it rejected a request from the Trump Administration to allow construction of the Keystone XL crude oil pipeline that had been blocked by a Federal judge in Montana.

But the most stunning legal development was the ruling by U.S. District Judge James E. Boasberg that the Dakota Access Pipeline (“DAPL”) must immediately cease operations and remove all the crude in it within 30 days. DAPL’s construction under Lake Oahe, ND, near the Standing Rock Sioux Reservation, drew fierce protests from local Native Americans and others opposed to its construction. The Obama Administration was opposed to it. Following Trump’s election, the Army Corp of Engineers gave their approval and DAPL was completed. It has capacity of up to 570,000 barrels per day, moving crude from the Bakken in North Dakota to Patoka, IL.

The judge’s ruling finds fault with the approval issued by the Army Corps of Engineers, which was given on the basis of an Environmental Assessment (EA). The Court found that, given the controversial nature of the project, a more rigorous Environmental Impact Statement (EIS) was required under the National Environmental Policy Act (NEPA).

In summary, the judge believes the government incorrectly allowed the pipeline to be built.

Whether or not this is the case, ordering the pipeline to shut down defies common sense. The implication is that, even if the government issues a private company a permit, substantial economic risk remains if your opponents can find a compliant judge. DAPL could lose $1.2BN next year if it’s forced to close. Bakken crude production will face higher transportation costs as producers resort to rail, where spills are more likely. It may not even by physically possible to empty the pipeline within the 30 day deadline. The process includes pumping huge volumes of nitrogen into the pipeline to push a bullet-shaped “pig” through it.

There are numerous knock-on effects. Production may now be cut back in the face of higher transport costs, causing layoffs. Landowners who sold the pipeline the right to cross their land won’t get paid. North Dakota royalties on production will fall. One analyst suggested that Judge Boasberg was frustrated that the Army Corp of Engineers had concluded their EA was adequate even after the court told them to review their process. Under this interpretation, the judge is trying to punish the Army Corp of Engineers, although oversight of the Administration is more properly the role of Congress.

The ruling is being appealed, and DAPL may yet continue to operate if a higher court over-rules Judge Boasberg’s order to shut down the pipeline. For the judicial system to work, a more reasonable assessment is needed. But considerable uncertainty about DAPL’s future will remain, and if there’s a change in government in November, the Army Corps of Engineers may decide not to even issue an EIS, which they estimate will take 13 months. DAPL cost $7.5BN, substantially over budget because of numerous delays. It may never restart.

Energy Transfer (ET), who built DAPL and retains a 36.4% ownership stake, has earned a reputation for not backing down when opposed by environmental activists. But the implication of the ruling is that permit issuance by the Federal government can’t be relied upon when deploying capital. Whatever the merits of this particular case, a court shouldn’t be able to impose economic losses on a company that has obtained the necessary permit, just because the permit may have been issued incorrectly. Otherwise the permit recipient needs to review its own regulator for correct procedure. This is not how great nations are built.

The cancelation of ACP, the uncertainty over DAPL and the perpetual struggle to build Keystone XL will cast a shadow over every new pipeline project. Unpredictable legal delays have prevented the construction of nuclear power facilities in recent years – although most costs can be estimated, court challenges can burn up time and money in ways that are hard to anticipate. The private sector has concluded nuclear power is just not worth the trouble, impeding our use of this source of emission-free energy. The pipeline industry is going the same way.

Anti fossil-fuel activists have achieved a great victory. But they’ve also achieved what pipeline investors have failed to – a decreased appetite for new construction. The Shale Revolution has been a huge bust for equity investors in the U.S. energy sector, including midstream infrastructure. The old pipeline business that used to be dominated by MLPs did little new building, invested in maintenance of their existing assets and paid attractive distributions that grew through price hikes and productivity improvements.

Pipeline executives drank the same kool-aid as their upstream customers. Too often, growth projects failed to cover their cost of capital and acquisitions were based on unrealistic assumptions. The pursuit of growth has been, in aggregate, bad for investors. Canadian companies have been more disciplined, but the abject past decade’s performance of the Alerian MLP Index reflects poor capital allocation by management teams constantly building and buying.

Falling growth capex this year is the driver of increasing free cash flow (see Pipeline Cash Flows Will Still Double This Year). Last week’s court rulings are likely to further trim growth projects, which will be lamented by management teams but cheered by investors.

It’s also likely to increase the pricing power of existing infrastructure, especially where additional capacity is needed but unavailable due to growing legal uncertainty. If future customers ultimately can’t access natural gas because needed pipeline capacity wasn’t built, that will be someone else’s problem. Maybe a more predictable legal process will evolve, but for now it is clearly opaque and sometimes capricious.

Don’t let the disappointment that will be heard on 2Q earnings calls confuse you. Many of these companies developed a culture of always building. In the future, growth projects will be more modest additions to existing infrastructure where permit jeopardy isn’t a factor. Buffett is unlikely to pursue controversial new pipeline construction for the business he just acquired, and he sees much to like about its prospects. Climate activists are doing long-term pipeline investors a favor. Few would expect us to admit that! Barriers to entry are becoming insurmountable.

History is about people, and personal connections always add interest. On hearing we’d be visiting Charleston, SC a good friend, Austin Sayre, suggested we stop by his family’s ancestral home. The Colonel John Stuart House is in Charleston’s historic district, where many of the homes have a plaque describing their former owner’s significance. Colonel Stuart is one of Austin’s ancestors.

The plaque and Wikipedia together describe Colonel John Stuart, a Scottish rebel who later represented the British government in dealing with Native Americans. Born in 1718 in Inverness, he arrived in Charleston in 1748. During the Revolution, his loyalty to the British crown meant he had to flee Charleston, and his house was confiscated. Stuart died in Pensacola, FL in 1779. The British Commander-in-Chief in North America, General Sir Henry Clinton, lamented, “The loss of so faithful and useful a servant to His Majesty.”

Charleston is a beautiful old city. Dozens of fine homes in the historic district have been restored, and it’s absorbing to stroll among them while reading about the lives of former residents. The water front is picturesque, and is best experienced on foot wandering down the narrow streets. The city also provided our first meal out in three months (see Having a Better Pandemic in Charleston, SC).

There’s more to the story. John Stuart didn’t just sail for the new world in search of opportunity. He was fleeing for his life. In 1745 Charles Edward Stuart (“Bonnie Prince Charlie”) led the Jacobite rebellion, which sought to overthrow King George II in favor of Bonnie Prince Charlie’s father, who was waiting in France. John Stuart, clearly of the same clan and therefore related, joined the uprising. It was put down at the Battle of Culloden in 1746, where the English won a decisive victory.

What remained of the Scottish army returned to their homes in the Scottish highlands. But King George II sought revenge against the treasonous officers who had led the uprising. John Stuart was wanted, and likely faced execution if caught. He and his brother Francis left Britain, on a ship that brought them to Charleston. There, John Stuart eventually built the house we had visited, and his descendants ultimately included Austin Sayre.

Incidentally, the TV series Outlander portrays the events around Culloden, including the battle, in a number of gripping episodes.

I contemplated this historical vignette and my connection with it. Part of it didn’t add up. John Stuart had gone to war against the British Crown in 1746, following which he had fled the country. Just 14 years after Culloden, we find Captain John Stuart in the local militia fighting the Cherokee Indians.  He was captured, but later released in exchange for a ransom.  In 1762, Stuart’s familiarity with Native Americans led the British to appoint him Crown Superintendent for Indian Affairs in the South.

During the Revolution, John Stuart’s loyalty to the Crown forced him to flee again, this time from Charleston. Why did this former rebel later pledge fealty to the king?

I asked Austin, who shared the story passed down to him through his family. King George II died in 1760. He was succeeded by his grandson, George III, whose father, Frederick, Prince of Wales, had died in 1751 of a lung injury. Sometime after George III’s accession, John Stuart and his brother Francis sought a royal pardon from the new king. George III was looking for friends in the colonies, and was perhaps also influenced by John Stuart’s service in the 1759-61 Anglo-Cherokee war.  Both brothers were pardoned. This is why the Scottish rebel spent his later years as a loyal subject. What a fascinating twist!

Francis subsequently returned to Britain, but John remained in Charleston until the Revolution. He built his house between 1767 and 1772, by which time he was Colonel John Stuart.

It’s an obscure piece of history. The story was made real for us through visiting the home once owned by our friend’s ancestor, and supplemented with additional information. Charleston felt closer to Britain than does everyday life in New Jersey, because its early history is so vividly British. Our shared histories are why, for this Brit, America has so easily been home for 38 years and will be for the rest of my life.

I am descended overwhelmingly from English stock – my ancestors might even have been on the opposing side at Culloden, although Austin Sayre is too much of a gentleman to retain a grudge. Colonel John Stuart no doubt lamented the 1776 Declaration of Independence, but Austin and I agree that Britain’s loss was the world’s gain. We are a great country navigating a tough patch. We’ll make it to the other side. We always do.