Energy remains probably the least loved of the S&P500’s 11 sectors. Over-investing in new projects has turned off many investors, who would like to see more cash returned via buybacks and dividends. And the Democratic primary debates remind that an anti-fossil fuel stance is needed to excite the party’s hard core, introducing some electoral uncertainty to the outlook.

The good news is that cash flows are growing, as pipeline companies are responding positively to investor feedback (see The Coming Pipeline Cash Gusher). And the aspirational goals of some Democrats to phase out oil and gas will collide with technical realities and popular reluctance to return to 18^th century living standards.

Earnings season is generally confirming the positive free cash flow story we’ve articulated for midstream energy infrastructure (see The Coming Pipeline Cash Gusher). Enterprise Products Partners (EPD) continues to execute well, beating EBITDA expectations by around 10% with 18% year-on-year growth. Williams Companies (WMB) modestly exceeded expectations and provided good guidance, boosting the stock. This highlights that weak natural gas prices, which had kept the stock under pressure for a couple of weeks, have little impact on operating performance.

TC Energy (TRP, formerly known as Transcanada) reported another solid quarter. And Oneok (OKE) reported Distributable Cash Flow (DCF, the cash generated from existing assets after maintenance expense), of $541MM, $100MM ahead of expectations. Only Western Gas (WES) bucked the trend, with poorly-timed lower guidance just when Occidental (OXY) is considering selling their position following the acquisition of Anadarko (ADC).

Midstream energy infrastructure has undergone a transformation in recent years. Predictable and rising distributions were abandoned when the Shale Revolution required new pipelines. Income seeking investors felt betrayed, and many big MLPs converted to corporations so as to access a far broader set of investors (see It’s the Distributions, Stupid). Today, MLP-dedicated investors are missing two thirds of the sector including most of the big companies.

The ten biggest companies comprise the bulk of the industry. Dividends average 6.4%, comfortably covered by 10.8% DCF, which is growing at 9%. Leverage is down, at 4.1X Debt:EBITDA, and all are investment grade. Yields on their bonds are typically less than half their dividend yields, revealing that banks and rating agencies, with their access to proprietary information are far more optimistic than equity investors.

The positives include:

• Capex on new projects, which continues to fall from last year’s peak
• Improved governance for those MLPs that have converted to a corporate structure. This makes them more attractive to institutional buyers.
• Stronger balance sheets, especially compared to more levered sectors such as REITs and utilities where over 5X Debt:EBITDA is common
• Low borrowing costs
• Interest from private equity, whose managers see better value in public markets. IFM’s acquisition of Buckeye Partners for a 27.5% premium earlier this year was an example
• Free Cash Flow growth which is on course to leap from $1BN last year to $45BN by 2021, based on our analysis of the companies in the broadly-based American Energy Independence Index.

2Q19 earnings reports are so far confirming all the positives noted above. Midstream is out of favor, cheap and poised to rise.

We are invested in EPD, OKE, TRP, and WMB

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).

Investing in midstream energy infrastructure today means pipelines, storage, gathering and processing and all the physical networks that sit between oil and gas wells and their customers. It doesn’t have to be limited to servicing non-coal fossil fuels. We research and think about other sources of energy including nuclear, renewables and coal.  We prefer the more visible cashflows that come with handling and transporting energy over the cyclicality and capital intensity of production and generation. It’s why we have avoided upstream oil and gas, coal mining, and power generation companies.

Mining and burning coal releases many pollutants including nitrous oxide, sulfur dioxide, particulate matter and other pollutants. It is in long-term decline in North America.  Furthermore, transportation is by rail and ship, which have lower barriers to entry than pipelines.

Public opposition to nuclear has added uncertainty and harmed economics, which makes investing unattractive.

However, renewables offer the opportunity for both long haul transmission lines and large scale storage. These are two areas with the potential for visible, persistent cashflows, although today there are few opportunities for scale and pure plays. Renewable generation is largely owned by utilities within portfolios that include coal, natural gas, and nuclear assets.

An exception is NextEra Energy (NEE), the world’s biggest producer of wind and solar energy. They’re the largest component of the SPDR Utilities ETF (XLU). On a list of countries ranked by wind power generation, they would be 8^th. Just as the Shale Revolution has created ample opportunities to invest capital for growth, so has the burgeoning renewables business in the U.S., albeit with a wholly different response from investors.

Although energy investors have revolted against endless investments in more production and additional pipelines, NEE investors cheer the company’s stepped up commitment to renewables. Over the past year, their stock has returned 24%,  8% ahead of the S&P500 and 16% ahead of XLU. From 2015-18 NEE’s capex rose from $3.9BN to $6BN, a pace they expect to maintain over the next four years. They’re planning the world’s biggest battery center by a factor of 4X, in central Florida, to store intermittent renewable energy for later use when it’s not sunny or windy.

Much of this investment will be in new wind and solar generation, a sector NEE expects to enjoy 15% annual growth through 2030. This growth will be driven by declining prices for produced power. NEE expects improving technology to bring the cost per Megawatt Hour for wind and solar below all other sources.

CEO Jim Robo recently led an investor day during which his team enthused about the being a low-cost renewables company delivering the benefits of clean energy to customers and investors.

But here’s the catch. The company is plowing capital into assets that will depreciate, because continued efficiencies will lower the price of produced power. It’s analogous to holding a huge inventory of microchips when Moore’s Law dictates that the cost of computing power falls by 50% every 18 months; or of stocking millions of iphones, when the next version will drive down the price of the old ones.

Rapid advances in technology cause deflation in assets. While Intel and Apple have shown that it’s highly profitable to manufacture products with continuous improvement, NEE is on the other side of this trade.

It means that every windmill they install and every battery facility they build is worth less than it cost from the moment it begins operation. The falling cost of renewable energy, which is driving their pursuit of growth, threatens to erode the pricing power of the assets they’re developing.

Correctly assessing the cash flow generating capability of a new solar facility must be hard. NEE can depreciate their property, plant and equipment (PP&E) based on the physical useful life of what they’ve bought, but the impact on cashflows from future pricing pressure is less clear. As their installed asset base ages, they’ll become less competitive, unless they constantly reinvest to upgrade their depreciating equipment. They face a constant uphill struggle to maintain competitive, cost-effective assets.  Eventually, they’ll reach a cash flow cliff as their contracts roll off.

In 2018, NEE’s depreciation of its renewables-heavy PP&E jumped, and is now higher than peers Duke Energy (DUK) and Dominion Energy (D), the 2^nd and 3^rd largest components of XLU respectively. At $3.9BN, it was two thirds of their growth capex. In other words, two thirds of their capex is spent to preserve the value of their PP&E. Assuming straight line depreciation, NEE expects its existing asset base to have a useful life of just over 18 years, which contrasts with the 35X earnings multiple assigned its stock by the market. Free Cash Flow has been declining as a percentage of net income, and will shift negative this year.

NEE is a company that’s investing heavily in the future, but will always be racing against advances in renewable technology. A purchase delayed will provide cheaper power, later. Advances in renewables may one day cause an impairment charge on old assets struggling to compete. A 10% write-down in PP&E would wipe out a year’s profits.

The irony is that pipelines regularly raise prices, and the sector has been punished by investors for spending on new infrastructure to transport growing oil and gas output. Disruptive pipeline startups are rare, because expanding an existing pipeline brings network effects and is cheaper than building new. Moreover, FERC’s regulatory framework  recognizes the oligopolistic role pipelines play and is designed to limit egregious pricing.

By contrast, NEE is being rewarded for investing heavily in assets whose pricing power diminishes. It’s true their customers are locked in via long term power purchase agreements. One of these is being challenged by bankrupt PG&E in California, although NEE is confident it will be upheld. But they still face the risk of lower-priced competition in the future, and no-one knows if regulators will allow them to charge customers rates above what new power assets would dictate indefinitely. Their potential competitors include new entrants unburdened by legacy, inefficient infrastructure. Even their customers can turn into energy providers by adding rooftop solar panels. The technology around renewables and battery storage continues to improve, creating the possibility of further disruption by new entrants.

We don’t own NEE. By all accounts they are a well-run company. Their progress will provide a useful guide to the growth of renewables in the U.S. and their ultimate profitability.

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).

Nothing exemplifies America’s low natural gas prices more than its flaring where takeaway infrastructure is inadequate. In the Permian basin in West Texas and New Mexico, from where most of the growth in crude production originates, associated natural gas is more often a disposal problem, like wastewater. Oil production has grown faster than expected, leaving gathering and processing systems struggling to keep up. Natural gas is hard to handle. Transportation by truck isn’t common because it has to be compressed, requiring specialized equipment. Mexican utility demand has grown more slowly than planned, and absent pipelines for transportation elsewhere in the U.S., the only remaining option is flaring.

A few years ago North Dakota faced a similar problem. Nighttime satellite photos revealed what looked like a new, brightly lit city in an uninhabited part of the country. Although regulators typically allow flaring for limited periods of six months or so, volumes of wasted gas continue to grow. By one estimate, the natural gas currently being flared in the Permian could power every home in Texas. The Texas Railroad Commission (RRC) regulates flaring permits. Oil drillers routinely request and receive permission for flaring where they can argue that oil can be profitably produced but there’s no take-away infrastructure for natural gas.

In theory, flaring requests can be challenged although they never are. Last week the RRC heard an application which raised an interesting question whose resolution could have a profound impact on such permits in the future. Exco Operating Company, LP sought a flaring permit on the basis of unavailable pipeline infrastructure. Unusually, it was protested by Williams Companies (WMB) who owns a nearby gathering and processing network. You can watch a video recording of the hearing here. Go to Item 9.

It turned out that a gathering pipeline was available to transport the associated natural gas, but Exco felt the economic terms were unfair. As the owner of the only available pipeline, Exco argued that WMB could charge an unfairly high price. Natural gas pricing at the Waha hub in Midland, TX has often been negative this year, meaning gas producers have to pay to offload their output. So it’s likely Exco was balking at pricing that reflected the paucity of options.

This led to an interesting dialogue between the RRC commissioners and representatives of Exco and WMB. The RRC has traditionally been charged with minimizing the waste of oil and gas. Natural gas flaring has been allowed because it’s necessary to access the crude oil. But Exco’s argument was one of economics. Implicit in their flaring request was that disposing of the natural gas would cost them more than its value.

As one commissioner noted, if flaring permits were based on economic hardship, there would be no need to have an approval process because companies would simply flare when that provided a better return than accessing a pipeline. And yet, the RRC is charged with regulating flaring, which means there must be some other, non-financial framework they’re intended to follow.

It was fascinating to watch both lawyers and the commissioners spar over this issue. WMB noted that the pipeline had been built at a cost of $1.5BN in order to gather gas from wells such as Exco’s, and said that Exco could have built their own takeaway pipeline early in the process but chose not to.

The RRC recognized the fundamental question raised by WMB’s challenge to Exco flaring application. It seems that however it’s resolved, it will set a precedent for future applications. Exco’s view would negate the need for the RRC to regulate flaring, since the decision would be a financial one for the company. WMB’s view would require drillers to access a gathering system where available even if pricing was unattractive.

The RRC decided to pass on the case at its first hearing, leaving it currently unresolved. When they meet to reconsider, the result could be far-reaching. If the RRC requires drillers to use available gathering and processing networks regardless of economics, as WMB wants, that would be good for pipeline investors.

Join us on Thursday, July 11th at 1pm EST for a webinar. We’ll discuss the pipeline sector’s growing Free Cash Flow. To register, please click here.

We are invested in WMB.

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’s blog (see Plain Talk, Fuzzy Math) showed how Plains All American (PAA) miscalculates its cost of equity capital. Equity is the key component in a company’s Weighted Average Cost of Capital (WACC). In the presentation from their investor day, it was too low. We received several comments from readers and investors on the topic. The energy industry has been plagued with executives who value growth in assets over achieving an appropriate Return On Invested Capital (ROIC). Profits come from ensuring that a company’s assets earn a return higher than the cost of financing them, or that ROIC > WACC.

In one meeting with PAA, we asked if they’d considered selling themselves, since there’s a case that the company’s worth more in another’s hands. “Not yet ready to retire” was the answer. Financial discipline comes in many forms.

In too many cases, a CEO’s pay is directly linked to a company’s size. Per share operating metrics and capital efficiency ought to dominate. Management teams often strive for growth, which can conflict with an owner’s desire to earn a good return. Identifying companies where interests are more clearly aligned with investors is worthwhile.

Calculating ROIC for energy infrastructure businesses is tricky. Projects are funded over several years, and project-based returns are generally not disclosed. Therefore, some judgment is required. Wells Fargo made a serious attempt at calculating company-specific ROIC figures last year. A couple of companies (Enterprise Products and Plains) preferred their own methodology over that used by Wells Fargo, and their objections were duly noted in the research report. We explained in last week’s blog why we disagreed with PAA’s approach.

One solution to poor capital allocation decisions is to favor public companies with a significant private equity investor. At first this might seem odd. Private Equity (PE) has delivered mediocre results for investors (see a recent WSJ article, Private-Equity Firms Are Raising Bigger and Bigger Funds. They Often Don’t Deliver). The problem for PE investors is the ubiquitous “2 and 20” fee structure, which is a big drag on returns and has created some fabulous fortunes. However, most PE managers are financially more astute than the typical pipeline company finance department. The best apply rigorous financial analysis, and investing alongside them can be an attractive proposition.

Having a PE partner doesn’t guarantee good judgment, but it does assure that when such decisions are being made, there will be a voice demanding a profitable spread between ROIC versus WACC. Private equity is all about capital efficiency and achieving an attractive IRR. Many energy companies could benefit from greater financial discipline. A few already have such a partner, reflecting the more optimistic outlook PE investors have of the sector compared with public market valuations.

Blackstone and its affiliates own 44% of Tallgrass Energy (TGE). Investors in TGE are in effect co-investing alongside Blackstone, without having to pay Blackstone a fee. It’s appealing to all TGE holders to know that capital allocation decisions require Blackstone’s support.

Crestwood (CEQP) is a similar situation, with their private equity partner First Reserve, who own 25% of CEQP and has also invested in JVs with CEQP on mutually beneficial terms.

Activists can also play a constructive role. In 2016 Carl Icahn pushed Cheniere’s (LNG) CEO Charif Souki out of the company. That’s one solution to the principal-agent problem. Souki is a colorful character (see Coals to Newcastle), but Icahn disagreed with LNG’s investments in oil companies, which were not linked to their core business of exporting liquefied natural gas. In an interview with CNBC, Icahn explained why, and also vented his frustration with Souki’s compensation. The subsequent improved capital allocation and focus on executing their core business plan has seen LNG stock rise from $39 at the time of Icahn’s intervention to $66 today, without paying a dividend.

Enterprise Products Partners (EPD) has a well-regarded reputation for prudent management. Growth projects are funded internally. The Duncan family owns a third of the company and controls EPD, helping align shareholder interests with managements.

Global Infrastructure Partners recently invested in Enlink Midstream (ENLC), and currently owns 41%. Texas Pacific Group and Goldman together own 12% in preferred securities which are convertible into common equity. It’s too early to judge the impact of their ownership, but encouragingly ENLC’s CEO Mike Garberding was previously the CFO. We think it’s highly likely that capital discipline will become apparent at ENLC.

Significant equity ownership by management doesn’t always lead to good decisions. Rich Kinder continued to add to his already significant holding in Kinder Morgan (KMI), even as it lost two thirds of its value from 2015-16. KMI investors could have benefitted from an influential outsider. Energy Transfer (ET) is also heavily owned by management, but trades at a steep valuation discount because CEO Kelcy Warren has shown a willingness to exploit his investors if he can (see Will Energy Transfer Act with Integrity?).

Prior to their simplification, the significant insider ownership at Plains may have led the GP to place too much leverage at the MLP level, leading to unsustainable dividends at the MLP before consolidation. In some cases, management teams whose interests weren’t aligned with investors under the old GP-MLP model have not yet altered their behavior to acknowledge the alignment of interests that simplification brings.

The addition of PE investors makes creating value for all stockholders a higher priority.  This requires disciplined capital allocation.  While Rich Kinder, Kelcy Warren, and the insiders at Plains still own significant stakes, they are holdovers from a different model of wealth creation.  Under their old structure, the GP directed the MLP’s activities while receiving preferential economics through Incentive Distribution Rights (IDRs).  Growing the MLP increased IDRs even if it diluted returns for MLP investors.

Kinder’s simplification was almost five years ago, and yet their continued use of DCF and EBITDA in evaluating their Enhanced Oil Recovery (EOR) business betrays that they still haven’t updated their thinking. Depleting assets such as these reduce the return earned by equity holders, while the GP and his IDRs are largely immune. As a simplified, single entity KMI still hasn’t shown that it understands its long term ROIC for the EOR business.

Plains is using flawed math for capital allocation decisions.  And, Kelcy may be back on the hunt for acquisitions to continue building his pipeline empire at ET.

The energy sector has been roundly criticized for overinvesting. Investors who favor companies where the rigor of PE analysis is applied to future projects could find that better capital allocation decisions follow. In our portfolios, we are biased towards companies likely to choose their investments wisely.

We invest in CEQP, ENCL, EPD,  ET, LNG, KMI, TGE, PAA via Plains GP Holdings.

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).

Plains All American (PAA) held their investor day last week. Continued growth in output from the Permian in West Texas is driving new pipeline construction, for which PAA is at the forefront. Limited pipeline capacity has hurt economics for some drillers that have resorted to trucks to move their crude, which is far more expensive.

PAA’s Supply and Logistics (S&L) business thrives on infrastructure constraints, since it allows them to exploit basis differentials using spare capacity on their pipeline network. From 2014-17 S&L EBITDA collapsed by 90%, as spare capacity came online. It has since rebounded to $450MM, around two thirds of its 2014 peak.

One analyst asked about the impact of new pipelines, both on the S&L business (where PAA expects to see EBITDA drop 50% next year) as well as on existing pipelines which face possible cannibalization of demand:

“You’re creating your own weather when you think of the S&L impact…there’s a lot of moving parts here…Loss of marketing, loss of basin flows, loss of potentially some spot barrels on Bridgetex”

Executives wouldn’t be drawn into discussing the impact in more detail, which was a pity because an investor day is supposed to offer an opportunity to dig more deeply into a company’s business. The response was:

“The guidance for this year fully reflects our views of how that impact is…we’ll give guidance later in the year for 2020… I don’t think we’re going to specifically work towards guidance during this meeting today, that’s not the intent.”

This interaction captures the conundrum facing investors. The Shale Revolution’s dramatic increase in oil and gas production isn’t yet profiting midstream infrastructure investors. One reason is fear that the industry will overbuild, pressuring pipeline tariffs and leading to projects that fail to cover their cost of capital.

PAA laudably tried to demonstrate financial discipline with two slides illustrating how they think about their cost of capital versus their return on invested capital. For any company, the spread between these two is the main source of profits.

So it was disappointing to see errors and omissions. Distributable Cash Flow (DCF) as a cost of equity was based simply on the current DCF yield without adding anticipated long term growth, though investors are told to expect such growth of 10% this year and presumably further growth beyond.

The problem in using current EBITDA as the basis for assessing projects is that it doesn’t reflect the long term return on assets with years of useful life and fluctuating tariffs. It omits corporate overhead, maintenance, cost for potential delays and cost overruns. Most investors calculate the net present value of cashflows from a proposed investment, discounted using a rate appropriate to the risk.

PAA isn’t calculating their cost of equity properly. More correct would be to use the dividend yield plus long term expected growth rate. The growth rate is derived from the portion of retained earnings not paid out (i.e.  1 minus the payout ratio) times the return on equity, which PAA shows has historically been 19.5%.

Although they’re targeting 130-150% coverage of their distribution, it’s currently 2X. Raising the dividend such that it was 150% covered would give them a yield of 8.5% (versus 6.37% currently). 150% coverage  equals a 67% payout ratio. 1 minus the payout ratio, or 33%, times their 19.5% ROE, implies a 6.5% growth rate, which should be added to the projected 8.5% dividend yield.

So PAA’s own figures and assumptions suggest their cost of equity is really around 15%, not the 12.1% they presented. PAA’s Weighted Average Cost of Capital (WACC), using their desired 55/45 equity/debt split and with a 4.25% interest rate on their debt, is almost 10.2%, 1.6% higher than they presented.

Since they seek an investment return of 3-5% above their WACC, any project needs a return of 13-15%. Riskier projects need an even higher return than this. The Alpha Crude Connector acquisition failed to meet this hurdle.

This minimum return on new projects is further illustrated through their desired leverage of 3-3.5X Debt:EBITDA. Assuming they continue to finance their investments with 45% debt, anything new must have an EBITDA multiple (i.e. cost of investment divided by EBITDA) of no higher than 7X. 3.25 leverage (the midpoint of their 3-3.5 range) divided by 45% debt share of finance is 7.2, which equates to around 14% (1 divided by 7.2), the midpoint of the required return we calculated based on their WACC.

The 55/45 ratio between equity and debt could be unsustainable if EBITDA falls. For example, a manageable 4X Debt:EBITDA leverage ratio would become an unsustainable 8X if EBITDA later dropped by half. Building in the possibility of lower tariffs in the future means debt should be less than 45% of the capital, which raises the WACC since equity is more expensive.

It’s also why you want to own strategic assets that don’t face huge drop-offs in revenues after initial contracts expire.

The flaw in PAA’s math can be illustrated by showing that they’d be willing to raise capital at today’s cost to buy an identical enterprise to their own, with identical EBITDA. Using their own cost of capital and 2019 EBITDA, they’d value this twin at over $33BN. Adjusting for debt, the twin’s equity would be worth $24BN, compared with PAA’s current market cap of only $17BN. Their math allows that PAA could pay up to a 39% premium to buy a business identical to what they own before the acquisition would no longer be accretive.

This is why investors are usually unenthusiastic when management teams announce another growth project. PAA, like most of its peers, should be more willing to repurchase shares.

The stock’s poor performance over the past five years is due to poor capital allocation decisions, probably driven by faulty logic such as described here.

No sell-side analyst pointed this out, but the shareholders who have lived it understand the flaws in PAA’ internal investment process.

Meanwhile, PAA is a cheap stock, trading at just 8X cash flows that are growing, assuming management is more prudent with investors’ money than over the past five years. The industry’s fortunes will turn on correctly calculating the spread between cost of, versus the return on, invested capital.

We are invested in PAA, via Plains GP Holdings.