Earnings season for pipeline companies has provided few surprises, offering little to offset fund outflows, which continue to weigh on performance. Therefore, the Tallgrass (TGE) call last Wednesday promised to be more interesting than most. Blackstone’s (BX) offer to take private the 56% of TGE it doesn’t already own has focused attention on a sideletter many investors find objectionable.

In January, BX bought 44% of TGE at $22.43. The General Partner (GP) of TGE, owned by CEO David Dehaemers and others, was separately valued at around $480MM, which meant that these insiders received $26.25 for their TGE units. A sideletter agreement allowed that if BX buys the rest of TGE within a year, regardless of price, the insiders will receive at least $26.25 for their remaining units (see Blackstone and Tallgrass Further Discredit the MLP Model).

To his credit, Dehaemers confronted the sideletter issue during the earnings call. He understands that resolution of BX’s offer is the biggest question hanging over the stock. Investors who long believed they were invested alongside management feel betrayed, because the sideletter places a floor under management’s sale price without providing similar protection to other investors.

Dehaemers seems to think critics are overlooking the fact that his GP stake justified additional value, and that the special terms for management are fair. The problem is not the additional value extracted for selling the GP, even though its valuation seems arbitrary. Breaking the alignment of interests is what’s so offensive.

.avia-image-container.av-qc53f2-2d0a6501242d959dbdf70a84a1cea76a img.avia_image{ box-shadow:none; } .avia-image-container.av-qc53f2-2d0a6501242d959dbdf70a84a1cea76a .av-image-caption-overlay-center{ color:#ffffff; }

The sideletter’s result is that Dehaemers and his management team are indifferent to the price BX offers for the rest of the units below $22.43, since in any consummated transaction they are assured of receiving $22.43 (plus $3.82 per unit for their GP stake, or $26.25 in total). This is why BX’s $19.50 offer is so galling. Perversely, as TGE’s stock price weakened in August, it increased the likelihood of BX offering to buy the rest of the company. Therefore, as TGE fell it raised the probability of management receiving $22.43 for their units. Dehaemers was completely misaligned with his investors. Blaming TGE’s stock weakness on institutional sellers misses the point. Dehaemers had willingly given up his right to acquire any units in the open market, and had little incentive to provide business updates that might have arrested the decline.

Dehaemers insisted on a floor to sell his remaining shares, guaranteeing him the original price, as a pre-condition to staying invested and agreeing on a non-compete if he leaves the company. Because this changed his incentives relative to other investors, maintaining alignment with them required that he either obtain the same floor for all investors, or not seek one for himself. In doing so he violated their trust, which relied on this continued alignment of interests.

The consequences extend beyond just TGE. By demonstrating how easily the senior managers of a partnership can negotiate preferential terms for themselves, TGE has followed in the steps of Energy Transfer (ET), whose 2016 issue of convertible preferred securities to management on highly attractive terms led to a class action lawsuit (see Will Energy Transfer Act with Integrity?). Partnerships trade at a valuation discount, reflecting the weakness of investor protections (see Energy Transfer’s Weak Governance Costs Them). The MLP-dominated Alerian MLP Index (AMZX) has lagged the corporation-dominated American Energy Independence Index (AEITR) by ten percentage points this year (see MLPs No Longer Represent Pipelines).

Regardless of how the BX offer is resolved, MLP investors now have to consider the possibility of management crafting lucrative deals for themselves, a risk typically not present with conventional corporations because of tighter governance. It’s why the biggest ESG funds invest in pipeline corporations but not MLPs (see ESG Investors Like Pipelines).

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).

Wildfire season began abruptly in California last week. Bankrupt utility PG&E’s planned widespread power outages are a response to last year’s fires, which were blamed on high winds and faulty transmission lines. Having friends in affected areas, as many of us do, certainly brings home the tragedy and fear that comes when you might lose your home. Claims for fire-related deaths and property destruction last season overwhelmed PG&E’s financial resources. Apportioning blame is complicated – what seems certain is that Californians will endure higher electricity prices – both to make up for underinvestment in transmission infrastructure as well as to achieve the state’s 2050 goal of lowering Greenhouse Gas (GHG) emissions to just 20% of their 1990 level.

Californian electricity prices average 16.6 cents per Kilowatt/Hour (KwH), substantially above the U.S. average of 10.5 cents, but still lower than New England (see An Expensive, Greenish Energy Strategy). The EU average is 23.4 cents, so there’s probably plenty of room for prices to rise. Energy in America is cheap. Stores on busy streets keep their doors open in summer, blasting cool air on to passers-by in hopes of luring them in. Energy prices are not a political issue. They may never be this cheap again.

.avia-image-container.av-21t3q7j-362044ef62d5d05b6d35e02b15a015c2 img.avia_image{ box-shadow:none; } .avia-image-container.av-21t3q7j-362044ef62d5d05b6d35e02b15a015c2 .av-image-caption-overlay-center{ color:#ffffff; }

Like the U.S., California’s GHG emissions peaked over ten years ago. But while President Trump withdrew America from the Paris Accord, California has adopted laws intended to reduce GHG emissions even below targets the Obama administration considered as part of its “Mid-Century Strategy”

Lowering emissions enjoys widespread support in California. They even have a cap-and-trade program, the subject of a recent lawsuit from the White House because it includes Quebec, possibly violating the Federal government’s exclusive responsibility for foreign policy

What’s interesting is to consider the political support for California’s laws mandating GHG reductions. Although it’s often noted that California’s GDP is bigger than all but seven countries, even that state’s planned 80% reduction in GHGs won’t save the planet. The heavy lifting is about to begin. The Transportation sector is 41% of California’s GHG emissions. Electric vehicle adoption will need to grow substantially. Demands on the state’s beleaguered electricity transmission infrastructure will correspondingly increase, although GHG emissions from the power sector are also expected to fall.

.avia-image-container.av-n7z10v-8c32db03d6922f89ce7141077e6c4606 img.avia_image{ box-shadow:none; } .avia-image-container.av-n7z10v-8c32db03d6922f89ce7141077e6c4606 .av-image-caption-overlay-center{ color:#ffffff; }

In 2017 Californians generated 424 Million tons of GHGs, pretty much the 1990 level. By 2030, state law mandates that annual emissions must be 40% lower, reduced by 170 Million tons of CO2 equivalent. The world generates 35 Gigatons, so the Golden State’s contribution will be to keep the world’s total 0.5% or so less than it otherwise would be.

California’s emissions policies are laudable. But global success unfortunately won’t come solely from this effort. Their hope is that they’ll set an example that other states and countries will adopt.

So it’s worth looking at China, where GHG emissions are expected to increase by over 2 Gigatons during the same period. The heroic efforts of Californians to slash their emissions over a decade will be offset by just nine months of growth in China.

.avia-image-container.av-14yga5r-b48b03fc121a916cce9895b1c6cfa14f img.avia_image{ box-shadow:none; } .avia-image-container.av-14yga5r-b48b03fc121a916cce9895b1c6cfa14f .av-image-caption-overlay-center{ color:#ffffff; }

This is the Climate Change Conundrum. The rich world says it wants lower emissions. California is a leader in this respect, although no country is on track to meet its Paris Agreement pledges. Meanwhile, developing countries like China and India plan sharply more energy consumption, so as to raise living standards. By accepting higher power prices, Californians are accommodating rising living standards in China by lowering their own. Moreover, poorer countries are far more exposed to rising sea levels and other consequences of climate change than richer states, which possess the resources to protect themselves. California is sitting on the high, dry moral ground.

The Paris Agreement isn’t working. Global emissions are rising. It’s the tragedy of the commons on a global scale. Californians will eventually realize that their substantial efforts are being hijacked as GHG emission capacity by others, rather than inspiring similarly noble, selfless acts. China, the world’s biggest emitter, is ranked “highly insufficient” by Climate Action Tracker for its efforts, as emissions continue to grow rapidly. The U.S., which emits half that of China, is ranked even lower, at “critically insufficient”, because of its withdrawal from the Paris Agreement despite lowering emissions more than any other country. Shifting energy intensive industries from America’s relatively clean energy mix to China’s is going in the wrong direction.

The current approach needs to be rethought. Perhaps what’s required is a set of agreed objectives that are attainable, even if those objectives fall short of what the UN’s IPCC report recommends. Extremists such as the precocious Greta Thunberg with her global scolding at the UN (“How dare you?”) and Extinction Rebellion are irritating or simply wacky. Movie stars who speak on climate change before hopping back onboard their private jet easily betray their hypocritical, virtue signaling goals. They make a few headlines, but the extreme solutions they advocate aren’t supported and aren’t being implemented. They are counter-productive.

.avia-image-container.av-tvfkj3-6f669827045e65ed42effaf0ddfe83af img.avia_image{ box-shadow:none; } .avia-image-container.av-tvfkj3-6f669827045e65ed42effaf0ddfe83af .av-image-caption-overlay-center{ color:#ffffff; }

There’s probably not much popular support in America for green policies to support higher living standards in Asia. What remains clear is that solutions should include substitution of one relatively clean fossil fuel (natural gas) for the dirtiest one (coal), since fossil fuels are what work. California relies on natural gas for 46% of its in-state power generation. Natural gas pipeline companies will be needed more than ever.

The Shale Revolution has substantially increased America’s output of oil, natural gas and natural gas liquids. We often use the chart below to highlight this exponential growth.

.avia-image-container.av-jb3v99-6293e44219e48a01597de723e6844b62 img.avia_image{ box-shadow:none; } .avia-image-container.av-jb3v99-6293e44219e48a01597de723e6844b62 .av-image-caption-overlay-center{ color:#ffffff; }

Those exponential curves are going to flatten, not only because nothing can rise that fast indefinitely, but also because of the high initial depletion rates of fracked wells.

.avia-image-container.av-1msokd9-05585c146dd9db55cf64ed294a4bb28d img.avia_image{ box-shadow:none; } .avia-image-container.av-1msokd9-05585c146dd9db55cf64ed294a4bb28d .av-image-caption-overlay-center{ color:#ffffff; }

The chart above from Goldman Sachs provides a useful picture of shale oil production, which shows a gently flattening growth curve. It can be helpful to examine more closely how the lifecycles of cumulative wells combine to render growth ever harder to achieve.

The chart below is a theoretical model, showing a shale oil play in which production drops at 50% annually from previously drilled wells, while at the same time new wells are fracked each year with initial production of 1.6 million barrels per day (MMB/D).

.avia-image-container.av-12xa3vh-94da7578ca4bcba2b881d517decbe7e3 img.avia_image{ box-shadow:none; } .avia-image-container.av-12xa3vh-94da7578ca4bcba2b881d517decbe7e3 .av-image-caption-overlay-center{ color:#ffffff; }

It’s a busy chart but worth a moment to examine carefully.

Year 1 production of 1.6 MMB/D experiences 50% depletion in Year 2, of 0.8 MMB/D. But new production of another 1.6 MMB/D raises Year 2 total productioln to 2.4 MMB/D, a 50% jump.

Follow the successive depletion arrows from Year 1 production through Years 3-5, and you’ll see that they’re joined by depletion from later years of production. By Year 5, depletion from the four prior years totals 1.5 MMB/D, almost negating that year’s new production.

This illustrates a fundamental advantage of “tight” oil over conventional production. Output can rise very quickly and capital is invested over time in successive wells. This creates the short-cycle feature since capital is recycled very quickly (see Shale Cycles Faster, Boosting Returns). Moreover, if prices drop in, say, Year 3 the E&P company in this example can simply stop drilling. Production quickly plummets, since New Production is at least half of Total Production.

The model is intended to provide a couple of insights. One is that after an initial ramp up, production has to flatten. The other is that production can quickly fall, and following an initial sharp recovery starts to plateau again. This is visible on the Goldman chart during the 2014-16 oil collapse.

Our model is simplistic to illustrate a point. Productivity continues to improve, technology enhancements are regularly found, and the most productive areas are often drilled first. These and other factors will all obscure the depletion effect illustrated.

.avia-image-container.av-vosypp-29c0f62d4c4607e37da96075692bf9da img.avia_image{ box-shadow:none; } .avia-image-container.av-vosypp-29c0f62d4c4607e37da96075692bf9da .av-image-caption-overlay-center{ color:#ffffff; }

The chart above is an estimate of what we expect U.S. shale oil production growth to be from now until 2025.

.avia-image-container.av-vhu6xp-1516417ce60c7880056c605248e1d1f4 img.avia_image{ box-shadow:none; } .avia-image-container.av-vhu6xp-1516417ce60c7880056c605248e1d1f4 .av-image-caption-overlay-center{ color:#ffffff; }

A final interesting note is that this depletion effect is much more pronounced with oil wells versus natural gas. Crude wells experience faster initial depletion. This tends to shift the Oil-Gas ratio in favor of the latter, and also means that the inexorable drag on total output caused by depletion is less pronounced for natural gas wells compared with crude oil. The pair of charts above illustrate this. It’s partly why natural gas output is likely to continue growing, keeping prices depressed. By contrast, growth in U.S. crude output is likely to moderate. This is net bearish for natural gas prices and bullish for oil.

If you missed our webinar last week, titled “Volumes, Cashflow and ESG”, here’s a link to a replay.

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).

The rapid transition of WeWork from IPO in early September to almost bankrupt says something about the superficial due diligence of bankers prior to a roadshow. Reports suggest that co-founder Adam Neumann’s $1.7BN million payoff in exchange for much of his stock and his board seat will save him from having to file for personal bankruptcy. Like the late Aubrey McClendon when he ran Chesapeake, Neumann bet everything by borrowing heavily against his equity holdings. Meanwhile, Softbank has invested over $10BN into a company whose equity is now worth at $8BN. In January, WeWork was valued at $47BN. Another report suggested that layoffs were delayed because the company didn’t have the cash for severance payments.

Few will shed a tear for Neumann or Softbank. If you aim high and miss, down’s a long way. Founders and investors in a company can be expected to talk up its valuation.

.avia-image-container.av-w5j8sh-869da408cd015d838468b4edd7a75fe2 img.avia_image{ box-shadow:none; } .avia-image-container.av-w5j8sh-869da408cd015d838468b4edd7a75fe2 .av-image-caption-overlay-center{ color:#ffffff; }

But what about the bankers, who only a few weeks ago were out there pitching a hot growth stock that in reality was desperately in need of cash simply to stay afloat? We’re not natural IPO buyers, but doesn’t this company just sign long term property leases and then sub-lease for shorter terms?

Stocks can dip after an IPO, but it’s rare for bankers to so misread investor sentiment that the deal is cancelled. Early this year there were over 300 high growth, private companies valued at over $1BN (“unicorns”). Some mutual funds sought to boost returns on their public equity portfolios with a sprinkling of unicorns. That strategy has recently backfired, as Uber, Lyft and Peloton all slumped following their recent IPOs.

.avia-image-container.av-1qxen9d-e9f5dcd851cf2e04ec1be1b4c31a1d93 img.avia_image{ box-shadow:none; } .avia-image-container.av-1qxen9d-e9f5dcd851cf2e04ec1be1b4c31a1d93 .av-image-caption-overlay-center{ color:#ffffff; }

Investors seem to be recovering a protective layer of cynicism.

A close family member is an astute investor with an age-appropriate, conservative portfolio. She allocates a small portion for interesting, risky ideas, and bought into Tilray (TLRY) in its Canadian IPO in July 2018. CFA charterholders shouldn’t bother looking at marijuana stocks. Farmers all over the world rely on enormous government subsidies, without which their businesses apparently couldn’t survive. This simple observation, along with TLRY’s stratospheric multiples, supported my advice to my wife not to follow our relative’s lead. TLRY quickly soared to almost six times its IPO.

.avia-image-container.av-1bel6v5-113c11db7065d8f35cdf1bc8361cfe6f img.avia_image{ box-shadow:none; } .avia-image-container.av-1bel6v5-113c11db7065d8f35cdf1bc8361cfe6f .av-image-caption-overlay-center{ color:#ffffff; }

Our family’s most ruthless trader sold enough near the high to cover her cost within three months, as one of the most beautiful short squeezes in recent years swept away those who had shorted TLRY based on fundamentals. It’s been an occasional topic in our house at breakfast, along the lines of “Do you know what I could have bought if you hadn’t told me to avoid that pot stock?” Responding that my wife doesn’t pay enough in fees to warrant an account review while I’m eating my cereal draws a predictable retort.

.avia-image-container.av-jdsbgh-a607bd3bcb3fbe5d50fa704bc608d022 img.avia_image{ box-shadow:none; } .avia-image-container.av-jdsbgh-a607bd3bcb3fbe5d50fa704bc608d022 .av-image-caption-overlay-center{ color:#ffffff; }

The time for frothy stocks has passed. In a year of strong equity returns, low volatility stocks are ahead, even though they’d be expected to lag at such times. The American Energy Independence Index, jammed full of cheap stocks and with nothing remotely unicorn-like, is keeping up the pace. Investors are turning towards tangible values with proven business models.

“Horrific. Terrible. Abysmal. The worst. Those are terms equity analysts are using to describe investors’ attitude toward energy stocks.”

This is from a recent Wall Street Journal article (see Energy Stocks Fall Faster Than Oil Prices).

Sentiment in the energy patch is poor. Too much spending with too little returned to shareholders is the main gripe, along with what seems like a tendency for the sector to follow crude prices lower but then fail to participate in any recovery.

The WSJ article goes on to note that over the past year, crude has dropped 26% while the S&P Exploration and Production index (denoted in the chart by its ETF, XOP) has lost almost half its value.

It’s especially odd when E&P operating performance has been improving. In I Can’t Make You Love Me – E&Ps’ Performance Belies Negative Investor Sentiment, RBN Energy walks through metrics including profitability, reserve replacement and shareholder returns (buybacks and dividends) to illustrate that domestic energy companies are heeding the criticisms of investors. So far, it’s not helping their stock prices.

The gloom is overshadowing the improving outlook for midstream energy infrastructure stocks. Earnings season will provide another opportunity to confirm that the sector remains on track to grow free cash flow (see The Coming Pipeline Cash Gusher). But it’s already becoming clear that the performance of pipeline stocks is deviating markedly from the upstream E&P companies that are their customers.

.avia-image-container.av-1751hxk-61145dd88b3b7cf3765a7e8e5a19eaf9 img.avia_image{ box-shadow:none; } .avia-image-container.av-1751hxk-61145dd88b3b7cf3765a7e8e5a19eaf9 .av-image-caption-overlay-center{ color:#ffffff; }

While XOP is down 49% over the past year, the American Energy Independence Index (AEITR) is close to flat, and was briefly positive following the attack on Saudi Arabia’s oil infrastructure. Although still lagging the S&P500, the sector has recovered from the 20% swoon during last year’s fourth quarter. E&P stocks remain a long way from recovery.

The AEITR is also 7% ahead of the Alerian MLP Index (AMZX) since last October, helped by inflows from ESG funds with their focus on standards of environmental, social and governance practices. The partnership-heavy AMZX holds little appeal to ESG investors, compared with the corporation-heavy AEITR where corporate governance provides stronger investor protections.

Weak commodity prices are another problem for E&P names. Natural gas gets less attention than crude oil, but prices for the benchmark Henry Hub recently sank to $2.25 per MCF (Thousand Cubic Feet). Production continues to grow strongly in the northeast, thanks to the Marcellus and Utica shale formations in Pennsylvania. But a shortage of pipeline capacity has recently led to a discount of as much as $1 per MCF, meaning Marcellus natural gas was worth as little as $1.25 per MCF locally.

Some E&P stocks are almost worthless. Range Resources (RRC) is a company we followed almost a decade ago. In the years preceding the 2014 peak in the energy sector, RRC traded above $50 and was briefly above $90. We liked the management team very much, but noticed that they continued to sell their own shares even while quietly confiding that they thought they could be acquired for $120. We sold out.

.avia-image-container.av-ktxw14-61bee61244af249dc5576b880c6c9613 img.avia_image{ box-shadow:none; } .avia-image-container.av-ktxw14-61bee61244af249dc5576b880c6c9613 .av-image-caption-overlay-center{ color:#ffffff; }

Today, RRC is at $3. In a recent presentation they claimed resource potential of 40 TCF (Trillion Cubic Feet) of natural gas, enough to meet all U.S. domestic consumption for around 16 months. In our write-up from a 2010 RRC presentation, we noted their claim to 30 TCF of resource potential at that time. Holders from nine years ago (if any remain) have lost 90% or more of their investment, and RRC has access to ever more copious volumes of natural gas.

The Shale Revolution has produced enormous output, but profits for upstream investors have been elusive. The sorry history of RRC reflects the frustration investors feel with energy stocks, with abundant resources coinciding with capital destruction.

That’s why it’s a welcome sight to see midstream stocks performing so much better than their customers – the link to commodity prices has been weakening over the past couple of years, and the toll-model of pipelines is once again providing some differentiation.

Earnings season for midstream energy infrastructure kicks off with Kinder Morgan (KMI) on Wednesday. In April we identified growing free cash flow (see The Coming Pipeline Cash Gusher) as the most important catalyst for higher security prices. We’ll be reviewing quarterly earnings for evidence that the sector remains on track to generate increasing amounts of excess cash that can be used to reduce debt, increase payouts and buy back stock. There should also be some useful guidance on activity from the sector’s upstream customers. Investors and analysts seems weary of persistent low valuations, so any positive surprises should draw buyers.

The American Energy Independence Index (AEITR) is +16.9% YTD, having pulled back around 3.5% so far in October. It’s 11% ahead of the Alerian MLP Index, because its 80% weighting towards corporations (more ESG-friendly) better reflects investor preferences, which is to favor pipeline corporations over MLPs (see MLPs No Longer Represent Pipelines and ESG Investors Like Pipelines)

.avia-image-container.av-2dqpjy-451949c65f2dc11dc5b82467697ea73f img.avia_image{ box-shadow:none; } .avia-image-container.av-2dqpjy-451949c65f2dc11dc5b82467697ea73f .av-image-caption-overlay-center{ color:#ffffff; }

Although earnings and company guidance ought to dominate sector performance in the weeks ahead, there are a growing number of macro and geopolitical issues that are impacting investor sentiment.

• Making a deal with China in time to eliminate this as a potential election-year negative seems obvious (see Trade Wars: End in Sight). However, the latest signs of agreement have left the market nonplussed given the fitful journey followed so far.
• Middle East. Like many observers, we were surprised at how quickly crude oil prices retraced gains following the attack on Saudi infrastructure. Clearly, oil traders regard any disruption of supplies as unlikely, even after the more recent missile attack on an Iranian tanker in the Red Sea near Jeddah. Nonetheless, American midstream energy infrastructure doesn’t face similar risks from terrorists or foreign powers.
• Another EU deadline approaches in this most riveting drama (see Another Gripping Episode of Brexit). This is of little global consequence unless the UK somehow leaves the EU without an agreement (a “hard Brexit”). This is unlikely, but not impossible if one bluff too many is called.

Earnings may be overshadowed by developments. Global slowdown fears continue to spread. 2019 S&P500 earnings estimates have been softening all year, from $178 per share last October to $164 now, according to Factset. Bond yields remain highly unattractive. The Equity Risk Premium still shows stocks as a far preferable investment (see Stocks Offer Bond Investors an Opening).

Bill Gross recently recommended investors load up on high quality dividend-yielding stocks rather than negative-yielding government debt. We think bond markets are distorted in part by rigid investment guidelines followed by pension funds that require them to maintain large fixed income allocations regardless of return prospects (see Pension Funds Keep Interest Rates Low).

Equities remain attractive, and pipeline stocks exceptionally so.

We are invested in KMI.

Wednesday’s blog, Energy Transfer’s Weak Governance Costs Them drew a record number of pageviews within a few hours of being posted. It’s not just because Energy Transfer (ET) is a large, widely held MLP. Much of the writing in the sector is from cheerleaders who don’t criticize the companies they follow, because it’ll hurt their business model. Commentary is largely anodyne, and useless. Running an investment firm that doesn’t have a complex web of relationships with its portfolio companies provides a wonderfully liberating writing environment.

Sometimes readers ask why we own a stock if we’ve just been critical of its management. It’s possible to find a stock attractively cheap, and yet lament prior actions of its executives. That’s often why it’s cheap. ET is a well-run company. CEO Kelcy Warren has assembled a team that knows how to execute. If investors trusted him more, the stock would be higher. It’s worth pointing out.

Pageviews on our blog reveal that investors find criticism far more helpful than sycophantic platitudes. For those who desire an irreverent spin on the energy sector delivered with rapier-like wit, follow @Mrs_Skilling, an anonymous and astute energy insider who will simultaneously educate and amuse you. Often, posts are laugh out loud funny.

.avia-image-container.av-pc4d65-0fec55968227e7cbf4497c5ae159c79f img.avia_image{ box-shadow:none; } .avia-image-container.av-pc4d65-0fec55968227e7cbf4497c5ae159c79f .av-image-caption-overlay-center{ color:#ffffff; }

In case it gets lost in the cut and thrust of calling out bad management behavior, U.S. midstream energy infrastructure is a compelling investment opportunity. The Shale Revolution is almost entirely an American success story (see Why the Shale Revolution Could Only Happen in America). The technology behind fracking was developed in America because new business formation, access to capital and constant striving for success are more present here than anywhere. Add to those advantages an already substantial energy sector with thousands of skilled workers supported by extensive infrastructure.

Privately-owned mineral rights are an additional unique feature that allows landowners to negotiate with energy companies to extract what lies beneath on mutually beneficial terms. Mineral rights belong to the government all over the world, including in the UK, whose legal system is the basis for much of ours.

The result has been an American energy renaissance that has released new supplies of oil and gas, and made the U.S. the world’s biggest producer. Ten years ago few thought such an outcome possible.

Moreover, shale production is short cycle (see Shale Cycles Faster, Boosting Returns). Because the deployment of capital is more synchronized with production than conventional projects (think years and $BNs spent before production emerges as the traditional model), it’s less risky. Capital is recycled more rapidly, allowing production to be more responsive to price changes.

This is why it’s attracting the world’s biggest oil and gas companies. Exxon Mobil (XOM) is the most active driller in the Permian basin in Texas, where it is targeting one million barrels per day (MMB/D) of output in five years. Chevron (CVX) is close behind, with a 0.9 MMB/D goal.

Warren Buffett famously quipped that, had he been at Kitty Hawk in 1903 he could have shot down the Wright Brothers’ plane, thereby saving future airline investors from losing $BNs over the following decades. History is full of great ideas that didn’t immediately profit their inventors, often because too much capital followed the opportunity.

U.S. shale production of oil, gas and natural gas liquids will find a level at which returns on invested capital are adequate. It may already be there. It’s not always clear whose investment in upstream production will be most profitable. In the Barnett Shale, where the shale boom began, production peaked in late 2011 and only a handful of rigs remain active today.

Output will ultimately calibrate to a sustainable level of capital investment. Countless companies have provided proof of concept, although investment returns have been frustratingly disappointing. The growing presence of XOM and CVX is substantial confirmation that this is a permanent piece of the world’s energy markets.

Shale production has performed far better than investments in it. Midstream infrastructure, the pipelines, storage assets and processing facilities that sit between the wellhead and the customer, remains out of favor despite record volumes. This is also largely an issue of capital allocation, with the original income-seeking investors understandably alienated as the sector cut distributions to pay for new growth projects (see It’s the Distributions, Stupid!). But capex is falling, finally setting the stage for a surge in free cash flow (see The Coming Pipeline Cash Gusher).

Criticism of individual companies is intended to draw attention to ways they could improve their behavior, lifting stock prices to the benefit of all investors. The Shale Revolution remains a huge success story for production, highlighting much that is great about America.  The companies that own these critical pipelines linking producers to consumers will continue to benefit from these growing volumes. Those who focus on valuations rather than past performance are likely to realize commensurate returns in the midstream.

We are invested in ET

Three years ago, Energy Transfer Equity (then ETE, now ET following its 2018 simplification) cleverly extricated itself from a ruinous attempted acquisition of Williams Companies (WMB). Having relentlessly pursued his target, ETE CEO Kelcy Warren came to regret the terms he’d offered as rating agencies criticized the overly leveraged contemplated combined entity.

Having failed to renegotiate, ETE’s lawyers ingeniously devised a special issue of securities restricted to ETE management. By diluting the subsequent value of ETE units, it had the effect of lowering the value of the proposed combination to WMB shareholders while protecting ETE insiders against any dilution (see Is Energy Transfer Fleecing Its Investors?). Convertible preferred securities were issued to approximately 31% of ETE’s unitholders (that being the portion held by management), that allowed its dividend to be reinvested in new ETE units at a low price only briefly touched. Most ETE investors would likely have invested in such attractive securities had they been more widely offered. But WMB opposed their wider distribution, as they were allowed to under the terms of the merger proposal, predictably since they recognized the dilutive effect of their issuance.

.avia-image-container.av-2m2rxi-02b2d22c780ecc651fff2e40ba316846 img.avia_image{ box-shadow:none; } .avia-image-container.av-2m2rxi-02b2d22c780ecc651fff2e40ba316846 .av-image-caption-overlay-center{ color:#ffffff; }

Ultimately, ETE was able to extricate itself by noting unfavorable tax treatment that would diminish the transaction’s value. The convertible preferreds, originally believed by many to exist solely as a means of destroying the deal’s value to WMB shareholders, remained following its cancellation. Thus did Kelcy Warren cement his reputation as a CEO willing to unethically extract value from his fellow owners when such opportunities present themselves.

A class action lawsuit was filed, and ETE successfully defended itself. The law was on its side, even though many investors felt cheated.

It’s interesting to look back over the three years that have passed and assess whether Kelcy’s reputation for self-dealing remains a burden on Energy Transfer (now ET following its simplification).

Operating performance remains strong. ET regularly beats expectations for quarterly earnings but its stock remains stubbornly undervalued (see Why Energy Transfer Can’t Get Respect). Earnings calls often include questions on what ET can do to get the stock higher, with Kelcy lamenting the market’s lack of appreciation for his team’s value creation.

By most measures ET is attractive. It offers a 9.6% yield, almost 2X covered by Distributable Cash Flow (DCF). Leverage is coming down and their growth projects are self-funded, meaning there’s no additional sale of equity to raise cash.

Master Limited Partnerships (MLPs) offer weaker governance protections to investors than corporations. Tallgrass Equity (TGE) recently demonstrated this when Blackstone’s (BX) offer to acquire the 56% of the company they don’t already own drew attention to a sideletter providing a higher sale price of TGE stock held by management in such an eventuality (see Blackstone and Tallgrass Further Discredit the MLP Model). TGE CEO David Dehaemers showed that the acquisition of a publicly traded partnership doesn’t require a big control premium paid to all the owners – only to management.

It struck us, and ought to assault the sensibilities of every asset manager who owns TGE, that the CEOs of publicly traded partnerships are spectacularly unconstrained by the ethical standards  followed by the people who buy their stock. We invest alongside our clients like most CEOs, but the notion of selling our own shares in a jointly held position higher than our investors is unfathomable, and illegal. Evidently not so for TGE. Whether the BX deal is accepted or modified in some way to try and assuage the appalling optics, Dehaemers has joined Kelcy Warren in ignominy.

It’s become clear that weak governance is affecting the value of some MLPs. A few management teams are trusted to deal fairly, but ET may inadvertently be a casualty of TGE’s demonstration of who holds the high cards.

ET’s stock looks like a bond at the bottom of the capital structure. It pays a high yield easily supported by cash flow, but its holders (being equity investors) have no class of investor beneath them. The upside opportunity that usually compensates equity holders is denied ET investors, because in any sale of ET they should expect the control premium will somehow accrue only to management and not to all ET equity holders. TGE has shown how it can be done.

We calculated that ET insiders transferred over 1.3BN in unethical value to themselves through the convertible preferreds in 2016. However, given ET’s relative performance since then, it looks like a Faustian bargain. They’ve dissuaded investors whose purchases might have driven ET’s yield down by the 3% or so that would equate its valuation more closely with Enterprise Products Partners (EPD), another big MLP but without ET’s history. That would reprice ET stock 50% higher. The management’s team’s 13.5% stake (now lower, since the 2018 simplification resulted in a larger company) would be worth an additional $2.2BN, So the valuation haircut on management’s holdings is more than the 2016 transfer of value. Kelcy’s dubious ethics have burdened ET’s stock for the worse, costing everyone, including the people running the company.

We are invested in ET and EPD

Five years ago Russell Gold published The Boom: How Fracking Ignited the American Energy Revolution and Changed the World, one of several books that chronicled the Shale Revolution. Gold provided first-hand descriptions of fracking after persuading Marathon Oil to let him visit a site in North Dakota. He offers a fascinating description of the process that has transformed America’s energy production. We reviewed his book here. Gold displays his green credentials as he wrestles with the tradeoffs he perceives between abundant natural gas and the renewables growth it impedes. But on balance, he concludes that Shale has been good for America.

Russell Gold’s latest book, Superpower: One Man’s Quest to Transform American Energy seems at first to challenge the supremacy of the Shale Revolution and America’s energy renaissance. It follows Michael Skelly in his quest to harness wind power across the south eastern U.S. to provide electricity.

Gold recounts the early use of electricity, back in 1881 when J. P. Morgan’s New York townhouse was one of the first installations. The house was lit every day at 4pm, powered by a coal-burning steam generator whose noise and smoke upset the neighbors.

Highlighting the advantages of wind power may have been Gold’s intent, but after following Michael’s Skelly’s frustrating and ultimately unsuccessful attempt to transform power generation, this reader found the challenges more substantial than the opportunity.

The impediments Michael Skelly encountered were not technical. Texas produces a quarter of America’s wind powered electricity. On March 17, 2017 50% of all the electricity used in Texas came from wind. Renewables such as solar and wind suffer from intermittency (i.e. it’s not always sunny and windy). This can play havoc with grids juggling multiple sources of power. But ERCOT, the grid that covers Texas, has figured out how to maintain consistent power while allowing wind to increase its share beyond what many thought possible.

Size brings economies of scale, but with it comes concentrated power generation in wind areas with delivery over hundreds of miles of high voltage lines to those than need it. Skelly’s vision was to invest in extensive, large windmills that would sell their power across several states. But erecting huge electricity pylons to connect with users generated local opposition that often proved insurmountable.

Michael Skelly’s company, Clean Line, applied to Arkansas to operate as a public utility, since his fledgling company needed to build power lines linking Oklahoma and Tennessee. Back in 1935, Arkansas Power had been granted a monopoly by the state in return for building out the state’s grid.

It was a cleverly designed Catch 22 type regulatory structure designed by then-CEO of Arkansas Power, Harvey Couch – in order to be granted a public utility license, a company had to be a utility “owning or operating” power equipment serving customers. But you couldn’t be a utility without first having customers. The legislation had never contemplated the entry of a new company into the state’s power business. Nonetheless, the Public Service Commission denied Clean Line a license. The beneficiary was Entergy Arkansas, a descendent of Arkansas Power.

Clean Line’s frustration in Arkansas showed the fragmented nature of the U.S. electricity grid. Although it operates as three regions covering the eastern U.S., western U.S. and Texas, in reality each state approves local construction. Utilities in Oklahoma opposed Clean Line’s plans to construct transmission lines across the state, relying on a similar statute.  Whereas the Federal Energy Regulatory Commission oversees inter-state pipelines, there is no equivalent Federal agency responsible for inter-state transmission lines.

Political opposition arose in surprising places. Tennessee senator Lamar Alexander, who might have been expected to favor clean, cheap wind power for his state, instead came out publicly against the “…giant fifty-story wind turbines that they want to string along the Appalachian mountaintops…” Alexander had also opposed offshore wind turbines that threatened the view from his home in Nantucket.

Superpower sets out to show that technology exists, and that entrenched interests are the only barrier to far greater use of wind power. This glass half full interpretation sits alongside the half empty one – large scale construction of wind turbines and the high voltage power lines to connect windy, remote regions with population centers faces endless NIMBY opposition and barriers from entrenched interests. Arkansas didn’t care to allow power lines moving clean energy across its state with little in-state benefit. Wind power clearly works, as Texas has shown, and will continue to grow. Despite passionate employees, hundreds of millions of dollars and a decade of work a single HVDC line couldn’t even connect economic wind power from Oklahoma to Tennessee. The institutional barriers, large required investment in physical infrastructure and local opposition mean a national grid is unlikely to replicate the U.S. pipeline system anytime soon.

Superpower is an absorbing read, and well worthwhile to anyone interested in the development of renewal energy.

As recently as five years ago, the terms “MLPs” and “pipelines” were interchangeable. If you wanted to invest in pipelines for their steady growth and attractive tax-deferred yields, you had little choice but to be a K-1 tolerant, MLP investor. MLP-dedicated funds were developed to provide retail exposure to the sector, but the corporate tax burden has contributed to their disappointing performance (see MLP Funds Made for Uncle Sam).

A far bigger contributor to poor performance has been years of distribution cuts to fund growth (see It’s the Distributions, Stupid). Income generating businesses became growth-seeking, as the Shale Revolution drove the industry to reinvest more of its cash in infrastructure. America’s energy renaissance broke the MLP model.

This has led to a steady diminution of the importance of MLPs to the midstream energy infrastructure sector, since many of the biggest have converted to be corporations (“c-corps”). This makes them available to a far wider pool of investors than MLPs, which still generally struggle to attract significant institutional support.

.avia-image-container.av-2alb1d3-ee83632988bee990999f2a19bf8f3c47 img.avia_image{ box-shadow:none; } .avia-image-container.av-2alb1d3-ee83632988bee990999f2a19bf8f3c47 .av-image-caption-overlay-center{ color:#ffffff; }

One consequence is that the Alerian MLP Index (AMZX) is becoming steadily less representative of midstream. This is why two years ago we created the American Energy Independence Index (AEITR), recognizing that MLPs are only part of the story. AEITR limits partnerships to 20%, reflecting their diminshing importance and allowing investment products linked to it to be fully RIC-compliant with no corporate tax burden. AEITR also excludes MLPs that are controlled by a General Partner (GP), because of the weak rights such MLP investors have as well as the dilutive payments (called incentive distribution rights) from the MLP to the GP.

The shift to corporate form for the industry has left AMZX including only four of the ten biggest names in the sector in its index – because most of the giants are corporations. It’s also led to it being more concentrated – 70% of the index is in only ten names (versus 60% for AEITR) and 49% is in only five (versus 37%). And the market cap of the underlying names in AMZX is $257BN, only slightly more than half the AEITR’s $490BN.

Investors are increasingly shifting to broader exposure, which is why corporations have been outperforming MLPs. This is illustrated by the AEITR (80% corporations) leading the AMZX (100% partnerships) by 7% over the past twelve months.

.avia-image-container.av-1myc6fb-d02ee36e02e3c7b5d20af6901de4a8e8 img.avia_image{ box-shadow:none; } .avia-image-container.av-1myc6fb-d02ee36e02e3c7b5d20af6901de4a8e8 .av-image-caption-overlay-center{ color:#ffffff; }

Partnerships provide weaker protections to investors, especially on issues of governance. It’s why Energy Transfer (ET) was able to award preferential securities to management three years ago (see Will Energy Transfer Act with Integrity, written when misplaced hope remained that they might). More recently, Tallgrass (TGE) showed that it’s not above self-dealing either, when it became apparent that Blackstone’s bid to acquire the 56% it doesn’t yet own would trigger a sale of management’s TGE units at a far higher price via a sideletter (see Blackstone and Tallgrass Further Discredit the MLP Model). Asset managers observe far higher ethical standards than some public companies.

Weak governance is why many institutions avoid partnerships. A research report from JPMorgan recently noted that, “…given the proliferation of corporate governance problems in the MLP space, many generalist investors will not entertain the notion of discussing MLPs in our investor conversations.”

In 2018 there were no MLP IPOs, compared with 20 in 2013 and 18 in 2014. This year Diamondback floated a minority interest in their midstream business as Rattler Midstream (RTLR), but that company elected to be taxed as a corporation, seeking to broaden its appeal by providing a 1099. However RTLR has a partnership governance structure, which means fewer rights for RTLR investors.

.avia-image-container.av-148o7fr-45d6444b24c4847d2f9a402870b4fabd img.avia_image{ box-shadow:none; } .avia-image-container.av-148o7fr-45d6444b24c4847d2f9a402870b4fabd .av-image-caption-overlay-center{ color:#ffffff; }

Over $50BN is invested in vehicles that track MLP indices, much of it in tax-burdened funds. JPMorgan reports $2.5BN in outflows over the past year. The shrinking pool of MLPs is making them less representative, and poor performance has led to outflows, which in turn weighs on pricing.

Changing to a more representative index would require these funds to dump MLPs, which would further depress MLP valuations. As a result, Alerian continues to talk up the MLP structure with blogs such as the sycophantic TGE: Take-Private Bid Highlights Continued Private Equity Interest in Midstream. There’s no mention of the controversial sideletter noted above.

.avia-image-container.av-312wbr-e689155ab3216ca8884939edaeef40ae img.avia_image{ box-shadow:none; } .avia-image-container.av-312wbr-e689155ab3216ca8884939edaeef40ae .av-image-caption-overlay-center{ color:#ffffff; }

There continue to be some good MLPs, such as Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP) and Crestwood Equity Partners (CEQP). Some that are closely held see little value to incurring a corporate tax burden (see Pipeline Billionaires Cling to Partnership Model Others Shun).  ET is well run but undervalued, reflecting the perceived risk to investors of more questionable dealings by management. MLPs with a history of fair dealing receive a higher valuation than others. But poor governance remains a headwind to greater investor interest.

Surprisingly, ESG funds own several large midstream corporations including Kinder Morgan (KMI), Oneok (OKE) and Williams Companies (WMB) (see Improving disclosures is key to ESG investment in midstream, analysts say). Partnerships are not among the names held by ESG funds, because on “G” (Governance), they come up short.

Pipelines are no longer synonymous with MLPs, even though many funds behave as if they are. Fund flows and relative performance show investors are taking notice.

We are invested in CEQP, EPD, ET, KMI, MMP OKE, TGE and WMB