Just over three months ago, Saudi Arabian oil facilities were put out of action by a drone and missile strike. Oil prices jumped. It seemed indisputable than Iran was behind the attack – the sophistication was beyond that believed available to the Yemeni Houthi rebels who claimed responsibility. Saudi retaliation appeared inevitable, as half their oil production was taken offline.

Crude jumped, but the Saudis chose to ignore Iran’s provocation. Prices soon fell back as the market resumed its sanguine view of supply disruption.

So is it different this time? The assassination of Iran’s top military leader, General Qassem Soleimani, looks like a sharp escalation of tensions. Secretary of State Mike Pompeo justified it as preventing “an imminent” attack on U.S. citizens. Reportedly, both Presidents Bush Jr and Obama declined opportunities to kill Soleimani in the past, because they feared it would lead to war. Iran has so far pursued asymmetry, avoiding a hopeless direct military confrontation in favor of indirect responses under cover of plausible deniability. Will that strategy change?

The Shale Revolution affords the U.S. far more foreign policy flexibility, now that OPEC can’t cause lines of cars at gas stations. Substantially higher domestic production of hydrocarbons made America a net exporter of crude oil and petroleum products late last year. Qassem Soleimani might be alive today if not for fracking.

Near term bets on crude oil or the energy sector will turn on how events play out, and it’s easy to have misplaced conviction with so many possible scenarios. Exxon Mobil (XOM) operates in 38 countries. Some of their infrastructure, which includes three JVs in Saudi Arabia, may be vulnerable, Geopolitical risk comes with complexity.

This is not the case for U.S. midstream energy infrastructure. For this sector, “international” is limited to Canada and in some cases Mexico. Pipelines are hard to damage because they’re underground, and while aboveground facilities are certainly more vulnerable, America is not an easy place for terrorist operations.

The sector is cheap enough that an investor can awaiting a re-pricing catalyst, which could be conflict in the Middle East or simply the market’s ultimate recognition of improving fundamentals.

Although S&P500 valuations are historically high, at over 18X 2020 earnings, the five biggest North American midstream infrastructure names trade at almost a 20% discount. All five of these companies are in the American Energy Independence Index.

S&P Energy, having sunk to 4% of the S&P500, is at close to its cheapest relative multiple in a decade.

There’s no need to correctly forecast disruptive geopolitical events or react quickly to them. Pipeline stocks are cheap enough to provide holders with multiple potential ways to make money.

We are invested in all the names listed above.

Our blog has a Search function that allows users to quickly find what they’re looking for. One of our most often read blog posts is MLP Funds Made for Uncle Sam, which is easily found by entering “Sam” in the search box.

SL Advisors is a secular organization, but searching for the word “Christmas” generates a surprising number of results.

Some relate to the seasonal pattern in which November weakness in MLPs is followed by a rally into January. Why MLPs Make a Great Christmas Present, MLPs Lose That Christmas Spirit and MLPs Weak in November, As Usual all reference Christmas in the text.

In Stocks Are the Cheapest Since 2012 a year ago we welcomed Christmas as a respite from relentless selling. Stocks, including midstream energy infrastructure, duly rallied with our American Energy Independence Index gaining 20% since then.

Investor frustration with the sector was high at times during 2019, and few probably expected the year’s returns to finish where they are. Energy infrastructure has joined the festive season in recent weeks.

Although New Jersey is not having a white Christmas, it’s still too cold for golf. This remains one of our favorite cartoons.

We wish all of our readers a Merry Christmas, Happy Holidays, and much joyful time with family and friends.

Energy investors would still like to see less spending on growth projects than company executives are pursuing. Whenever a CEO announces new spending, there’s a palpable lack of enthusiasm. Given valuations, many companies could easily justify buying back stock as a higher return use of capital than building new infrastructure. The message is getting through, but not quickly enough in the opinion of many.

Part of the problem is the way companies present their growth plans. A recent investor presentation from Enlink (ENLC) illustrates the problem. Their 2020 Growth Capital Expenditures (“capex”) are listed as $275-375MM. The collapse in ENLC’s stock price this year has driven their dividend yield up to 25%, a lofty level they plan to maintain. Since stock repurchased would therefore generate a 25% return as they claim DCF coverage >1X, it’s hard to believe they carried out a rigorous analysis on where they plan to invest cash that clearly won’t be used to buy back stock. Theoretically, their capex plans will yield a higher return that their stock, the implausibility of which casts further doubt on their capital allocation.

However, the problem with the presentation is the focus on EBITDA multiples to illustrate the attractiveness of their capital program. Over two thirds of their projects will generate an adjusted EBITDA multiple of <4X. In other words, $100 invested will generate better than $25 of EBITDA.

By coincidence, ENLC’s projects offer a return similar to their dividend yield, perhaps justifying them as a better use of scarce funds rather than buybacks. But over half the projects are for natural gas well connects, gathering and compression. These are not long distance transportation pipelines, but narrow lines running to individual wells. Their volumes will begin strongly and deplete as output from the wells they’re servicing depletes.

The point is that projects should be evaluated on an NPV basis, taking account of all the future cashflows. An EBITDA multiple is a shorthand way of comparing projects, and only makes sense when that EBITDA is stable or growing. ENLC’s CFO presumably doesn’t assess projects that way.

The types of project ENLC is planning have declining EBITDA. Including them in their presentation the way ENLC does creates a misleading impression of highly attractive investments. When we asked ENLC about the absence of any decline assumption in their own capex guidance, they referred us to Devon Energy’s (DVN) comments on the issue. DVN is the big customer whose production ENLC’s capex are intended to service. DVN has forecast production declines rates from “high 20% to high 30%”. DVN isn’t claiming that production will be stable. So why is ENLC using the first year’s cash flow to justify the capex in its presentation?

ENLC must know that presenting an investment based on the first year’s cashflow doesn’t fairly present the longer term outlook. They should either model the EBITDA over several years to show the decline rate they expect, or present the NPV analysis that they’ve presumably done internally before committing capital. A cynic might believe ENLC is doing projects with a negative NPV because the first year’s EBITDA flatters their leverage ratio, temporarily boosting EBITDA and thereby lowering Debt:EBITDA.

Energy companies are being criticized for poor capital allocation – a more transparent and rigorous explanation of spending would help ease investor concerns.

ENLC has plenty of room for improvement in this area. We hope they do. We are invested in ENLC and believe it’s cheap. The market is not giving energy management teams the benefit of the doubt and their stock would benefit from our suggested improvements in their presentation.

The Alerian MLP Index now has almost a 24 year history. Investors whose experience pre-dates the 2014 high will fondly recall many strong years. Since 1996 the compounded annual return is 11.3% including distributions, even though the AMZX remains 44% off its August 2014 high.

MLPs are a shrinking part of the midstream energy infrastructure sector, and the AMZX omits many of North America’s biggest pipeline companies, because they’re corporations not MLPs. Flows in MLPs and related funds are still dominated by retail investors, which is why the January effect has historically been more impactful than is generally the case for the S&P500.

The human tendency to take stock of one’s portfolio around year’s end is exacerbated by the impact of K-1s. Sell an MLP in December rather than January, and you’ll avoid a K-1 for that one month of the new year. Similarly, a purchase delayed from December to January avoids a K-1 for the last month of the prior year. Both these effects tend to lift prices in January versus December.

Tax loss selling is another feature that tends to weigh later in the year. U.S. equities are owned in large part by institutions that are often tax exempt, so tax planning has a more muted effect on the broader market.

Consequently, MLPs exhibit the seasonal pattern shown in the chart above. It may be some comfort for investors to be reminded that November is historically the best time to make investments in the sector. You’ll also note a smaller pattern around quarterly distributions, which generally fall in the middle of the quarter. Investors tend to avoid selling when a new distribution is imminent, so returns in the first month of the quarter are usually above average. It ought to make no difference at all – stock prices adjust for dividends paid when they go ex-dividend. Nonetheless, the pattern further suggests that sales made in the first month of the quarter will on average draw a higher price.

January stands out as a very strong month, returning three times the monthly average.

In recent years familiar patterns have been less reliable, including the tendency for MLPs to outperform the equity market (yes, they used to do that). The seasonals of the past five years reveal a very different pattern. As the sector has slumped, a clear trend has emerged of investors selling during the fourth quarter. The first half of the year has remained stronger than the second half, although oddly April has been better than January. Perhaps planned January purchases have been delayed because of prior weakness.

So far, October and November are continuing the pattern of 4Q weakness seen in recent years. We know anecdotally that tax loss selling has been a factor for some investors. It still looks to us as if a bounce in the early part of the new year remains likely. Sentiment is certainly consistent with current prices providing a near term low.

MLP seasonals remain interesting because of what they tell us about past retail investor behavior. Nonetheless, the MLP sector remains too small with too few well managed companies to justify a significant allocation. The American Energy Independence Index is 80% corporations with just a handful of MLPs. It’s +13% YTD compared with -5% for AMZX, starkly illustrating the preference investors have for pipeline corporations over MLPs, and the steady exit of retail investors from MLP-dominated products. Note that you cannot invest directly in an index.

We manage an ETF which seeks to track the American Energy Independence Index.

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