For constitutional observers, each weekly Brexit installment leaves viewers on the edge of their seats, pondering what further twists in the drama remain. Most recently, England’s Supreme Court ruled against Conservative Prime Minister Boris Johnson’s suspension of Parliament. Intended to stifle parliamentary debate during the run-up to Britain’s next Brexit deadline of October 31, the PM had argued that the extended closure was a normal prorogation leading to the Queen’s speech opening parliament’s next session. Nobody was fooled, and Johnson has in effect been found to have provided illegal advice when he asked the Queen to suspend Parliament. Great embarrassment for PM and Monarch. Civil wars are fought for less.

Johnson’s premiership opened shakily last month. He lost four straight votes while Parliament passed a law preventing a hard Brexit. The PM had pledged to leave the EU on October 31, with or without a deal, and Parliament disagreed. He then tried to call an early election. But the opposition preferred him in office but not in power for a few more weeks, so voted that down too. The PM subsequently kicked 21 MPs out of the Conservative party, including Nick Soames, Churchill’s grandson.

As a vocal Brexit supporter, it’s entirely appropriate that Boris Johnson should be in power right now, so as to carry the burden of the policy he championed, and to explain any disruption in its execution.

The country where I grew up has suffered from a complete void of competent political leadership in recent years. David Cameron’s decision to hold the referendum on Brexit in 2016 unleashed the divisiveness that has dominated UK politics ever since. Leaving the EU is far too complex to be based on a simple Yes/No vote. It should have been fought through a general election, with the winner responsible for carrying it out. Except that none of the major political parties supported Brexit, a political gulf starkly exposed by the referendum. When politicians don’t reflect voters’ views, populism follows. It is democratic, if unsettling

If you know someone’s location you can pretty much guess how they voted. London and other large cities along with Scotland and Northern Ireland voted to remain, while suburban and rural England voted to leave. No wonder the Scots may seek independence from the UK, as they’re dragged unwillingly out of the EU. Although the vote was close (52%:48%), and didn’t provide any view on what type of EU exit was approved (though it probably wasn’t a hard Brexit), polls suggest that few voters’ positions have since moderated.

People regularly ask me how it’ll turn out. I don’t think anyone can be sure. Since Parliament has outlawed Brexit with no deal, but also failed to approve Theresa May’s exit deal when she was PM, another delay is possible. Johnson could negotiate a revised exit agreement and get it through Parliament, which will now be reconvening earlier because of the Supreme Court decision. But he’s lost his majority by ejecting Conservative MPs who previously voted against him, so he may fail in getting his deal through too.

Another Brexit delay would lead to a general election, on which Brexit would finally be the defining issue. It’s recasting normal voting patterns. The Conservatives are unambiguously the Brexit party.

Labor is led by Socialist Jeremy Corbyn, whose main accomplishment has been to offer such a dystopian vision of Britain under his premiership that Theresa May clung to power far longer than her inept negotiations should have allowed. Labor’s Brexit position is ambiguous, an odd posture when it’s the country #1 issue. They’re choosing strategic flexibility at the cost of votes.

The Lib-Dems are the Remain party. But they routinely run a distant third, which renders their popular vote vastly under-represented in Britain’s first past the post electoral system. Hence, Lib-Dem votes are often regarded as wasted, like voting for a third candidate in a U.S. presidential election.

As a result, Johnson is betting that he’ll romp home with a decisive majority over a divided Labor party and weakly supported Lib-Dems. So far his judgment has been poor on every big issue. So we’ll see how that turns out for him.

I have close friends on both sides of Brexit, and can well appreciate the emotions supporting leaving the EU even though I would have voted to Remain. I’ll be visiting the UK next week, and have little doubt it will be a topic of discussion.

In any event, I no longer vote in the UK, having emigrated over thirty years ago, thereby forfeiting my UK voting rights. Instead, I vote in the U.S. at every opportunity, including primaries and even school board elections. Brexit is an utterly absorbing spectacle for this transplanted Brit, safely ensconced in the U.S. Those who criticize America’s dysfunctional politics should watch the UK for a few days. Its democratic institutions are proving robust, in spite of the efforts of the current crop of leaders to break them.

EU history is full of late night crisis negotiations that avert catastrophe. Surely the biggest crisis of all will ultimately be resolved this way. My bet is that the UK will leave with a new deal, and as ill-advised as that move is, they’ll muddle through and things will work out. But there’s a wide range of possible outcomes, and next week I may change my mind again.

Early analysis of the twin attacks on Saudi Arabia’s oil infrastructure has focused on the length and severity of supply disruption. 5.7 Million Barrels per Day (MMB/D) of lost output is the biggest supply drop in history, although its impact will depend on how long it takes to repair the damage.

This misses two more important results: (1) the physical vulnerability of Middle Eastern energy infrastructure, and (2) the increasing odds of regional conflict.

The attack laid bare Saudi Arabia’s inability to defend itself or even intercept enemy drones traveling through its airspace. This is an embarrassing failure of the Saudi military to protect the kingdom’s vital infrastructure. Buyers of crude oil will need to consider the ability of suppliers to deliver on their commitments. A substantial portion of the world’s energy comes from unstable regions, and Saturday’s attack showed that it’s possible to create significant disruption by targeting chokepoints in the supply chain (Investors Look Warily at the Persian Gulf).

It’s not just crude oil that’s at risk, although that is the current focus. Qatar is the world’s biggest exporter of Liquified Natural Gas (LNG), sending around 10 Billion Cubic Feet per Day (BCF/D) through the Straits of Hormuz,  25% of the global LNG market. The five biggest export markets are in Asia, where 75% of LNG trade takes place.

The risk of disruption to LNG and seaborne crude trade is now higher. At the margin this all makes Middle East sourced hydrocarbons more expensive and less reliable. Higher maritime insurance, additional storage in case of supply disruption and all the related risks of doing trade in a region sliding towards open conflict will require market adjustment.

By contrast, the U.S. energy sector is a clear winner. Its infrastructure is geographically dispersed and protected by the world’s military superpower as well as two oceans. The reliability of American supply suddenly seems a bit more important.  Added to that, Canada’s export pipelines  connect to the U.S. providing another reliable 3.5MMB/D of oil supply.

U.S. midstream energy infrastructure also has more global importance, since the growing role of the U.S. as an exporter makes world markets more reliant on a producer able to lift production when needed.

The Permian basin, which accounts for most of U.S production growth, is only expected to add about 0.6 MMB/D over the next year, so won’t suddenly produce an additional 1 MMB/D. Sustained higher prices will assuredly lift output over time, but even short cycle shale has its limitations.  Large multi-pad wells that are the most economic can take up to a year and a half to bring online.

Markets have not really repriced the odds of the regional conflict spreading to include Iran directly rather than its proxies. We have noted before the link between the pre-1941 embargo on Japanese oil imports and the current embargo on Iranian exports. The problem is that the U.S. is not offering the Iranian regime a clear path out. Since open conflict would be disastrous, Iran is pursuing asymmetric conflict with plausible deniability. Moreover, the shift from mining tankers in the Gulf to attacking oil infrastructure is a clear ratcheting up. Whether intentional or not, this seems likely to provoke a response. Saudi Arabia’s rulers must be considering right now the type of military response required and whether they even have the capability to deliver it alone.

Public support in the U.S. for another major conflict in the Middle East is low, and the Shale Revolution affords us more geopolitical flexibility. But if the U.S. does not take a military role, the vacuum will force other countries to consider their willingness to risk further disruption to the 20MMB/D coming out of the region.

Middle Eastern energy supplies are more vulnerable to disruption that previously priced in financial markets (i.e. Brent-WTI spread). U.S. energy infrastructure has an important role to play in providing secure energy supplies. The Middle East is headed towards more open conflict between two big adversaries.

Markets seem to have focused so far only on the short term disruption and how long Saudi Aramco will need to restore supply – currently estimated at a few weeks, although on the weekend it was said to be only days.

We think this attack requires a significant recalibration of supply security. American energy assets look very attractive.

Breaking News — Drone attack disables Saudi crude ouput

Although we don’t normally highlight the favorable geopolitics of U.S. midstream energy infrastructure, this news does emphasize that much of the world’s crude oil comes from unstable regions. See WSJ story U.S. Insulated From Possible Supply Shock After Saudi Attack

Momentum Crash Supports Pipeline Sector

The action in equity markets last week was beneath the surface. Daily moves in the S&P500 were unremarkable, but a sharp turn in momentum stocks caused lots of churning.

The resulting shift into value was welcome news for energy investors. Momentum and Value had tracked each other reasonably well for the past year until May, when Momentum began to outperform.

Eventually midstream energy infrastructure (defined as the American Energy Independence Index, AEITR), and Value both weakened during the summer. By late August, Momentum had opened up a 14% gap against Value over the prior five months, with similar outperformance against AEITR.

As portfolio managers in the pipeline sector we often struggle to explain the moves in the stocks we own. Apart from earnings season, macroeconomic developments and fund flows dominate. This past period was especially hard to understand because 2Q19 earnings reports were generally as expected.

In September this trend has reversed (see Drop in hot stocks stirs memories of ‘quant quake’), for reasons no clearer than those that preceded it. Value is 8% ahead of Momentum since Labor Day, lifting the AEITR with it.

What’s behind this? Large pools of capital are deployed based on factor bets like Momentum and Value, relying on research that ascribes long term equity returns to them. Momentum has been outperforming Value for several years – since the peak in oil in 2014, which partly explains negative sentiment towards the energy sector since then.

During the summer, the difference in relative performance jumped sharply, leading to the recent correction. Perhaps slowing global growth has caused a reassessment of high fliers. It increasingly looks as if trade tariffs, which are simply import taxes, are spreading a chill across the world economy.

Momentum has slipped 9% against Value since August 29. This is an unusually fast correction. In 2016, Value outperformed Momentum by 10%. This lifted MLPs, with the Alerian MLP Index returning 18% that year.

If Value starts to regain favor, investors will find plenty of cheap stocks among midstream energy infrastructure.

Blackstone — Tallgrass

Two weeks ago Blackstone offered to acquire the 56% of Tallgrass Energy (TGE) it didn’t already own. The $19.50 per share price was below the $22.47 at which Blackstone had bought 44% earlier this year. But the sideletter allowing TGE management to sell at $26.25, regardless of the price received by other TGE shareholders, is unethical.

As we noted in Blackstone and Tallgrass Further Discredit the MLP Model, the deal exposed an ethical gulf between the prevailing standards at asset managers and the public companies we invest in. If we treated our investors the way TGE proposes to, our careers would be brief.

What’s surprising is the silence among other TGE investors as well as sell-side analysts. Few wish to risk upsetting either Blackstone or Tallgrass by pointing out the obvious. This failure to speak out is itself a disservice to clients.

Although there have been no further announcements since the proposal was made public, TGE’s stock has edged above the deal price. Some traders are betting that Blackstone will sweeten its offer. If that turns out to be the case, we’ll be happy to have helped.

We are invested in TGE

​To be an SEC-registered asset manager is to submit to extensive rules of behavior, all with the objective of protecting the clients. Where a portfolio manager invests personally alongside her clients, creating a desirable alignment of interests, regulations require that the client’s interests are placed ahead of the manager’s. The asset manager has a fiduciary obligation to the owners of the capital under management, and a web of regulations exists to this end. CFA charterholders agree to additional obligations regarding ethical behavior and the primacy of clients’ interests.

The recent offer from Blackstone (BX) to acquire the 56% of Tallgrass Energy LP (TGE) it doesn’t already own at $19.50 per share has revealed an ethical gulf between prevailing standards at the providers of capital versus the users. No SEC-registered asset manager could do to its investors what TGE management is doing to theirs.

When BX acquired 44% of TGE in January at $22.43, a regulatory filing of a sideletter outlined an unusual arrangement under which, if BX bought the rest of TGE within a year, TGE management could sell their shares at $26.25.

In April, TGE CEO David Dehaemers fielded questions as to whether this arrangement created a risk that BX might take advantage of weakness in TGE shares to buy the rest of the company cheaply. He was adamant that, “…there is no intention of Blackstone doing anything here untoward.” Dehaemers went on to note that, “I’ve still got $50 million and invested in that. And that is from money that I put in this thing. It’s not restricted stock in fact I’ve never gotten a share of restricted stock in the last seven years at this thing.

“And so I didn’t leave $50 million in this thing to lose money and that just simply [isn’t] going to happen.”

These comments led investors in TGE to erroneously believe that they were invested in TGE alongside Dehaemers.

TGE’s stock fell sharply in August, creating the conditions for BX to acquire the rest of the company. Perversely, the weaker TGE’s stock the more likely was BX to attempt the buyout. Since the buyout triggered the $26.25 sale price, Dehaemers and other senior management actually benefited from the stock falling.

Although the $19.50 “take private” offer was 36% above its price the day before, it was below where TGE had traded all year until the sharp drop in August.

One might initially regard the elevated price for management’s TGE shares as nothing more than a bonus for selling the company. But because the $26.25 price is independent of the price at which the company is sold, the sideletter breaks the alignment of interests that exists when management owns shares alongside investors. The price received by other TGE investors no longer impacts the management team’s economics.

Nobody has suggested TGE deliberately drove their stock lower. But management clearly had little incentive to arrest the decline. Questions on capex plans and recontracting of pipelines received frustratingly vague answers. A management team incented to drive the stock price up might have been more forthcoming. Clearly BX, as an insider, saw little to concern them in the company’s recent operating performance.

We’ve long liked David Dehaemers and what he has achieved at TGE. We’ve talked to him several times in the past. But we are deeply disappointed at this turn of events, which at best reflects a serious judgment lapse on his part.

TGE is a partnership, which means it has much weaker governance than if it was a corporation. Sideletters such as this are legal, whereas it’s hard to imagine such a device being employed if TGE was a regular c-corp. It seems that investors in partnerships cannot rely on management promises that they have “skin in the game”, and that shared outcomes are assured.

The energy sector already struggles to demonstrate responsible stewardship of capital. The weak corporate governance of MLPs has dissuaded many institutions from investing in them. Some, like TGE, have elected to “check the box” so as to be taxed like a corporation while retaining the partnership structure. Although this improves tax reporting by providing holders with a 1099 rather than the disliked K-1, the governance weaknesses remain.

The BX-TGE episode will tarnish all the partnerships that remain in midstream energy infrastructure. Investors have little reason to hope for a high-priced acquisition, since it seems management can negotiate a different price for themselves. What’s to stop Kelcy Warren selling control of Energy Transfer (ET) in exchange for the acquisition of just the management team’s shares at a substantial premium to what’s offered the other investors? It seems there’s very little, which alters the risk/return profile.

Partnerships trade at a discount, and this shows why.

In a podcast interview with Alerian’s Kenny Feng last year, Dehaemers recounted a time earlier in his career when he wanted to relocate his family back to Kansas City, so his two boys could attend a Jesuit school. So he must know as well as anyone that unethical behavior isn’t excused simply by pointing to its prior disclosure, as is the defence of the BX-TGE sideletter.

It shouldn’t be the case that the asset managers who invest in companies like TGE adhere to higher ethical standards than the companies do themselves, but that is how things work. The list of publicly traded partnerships that can be relied upon to refrain from such moves is a short one. Choosing to pay corporate taxes while retaining the partnership structure can only be justified by managements that desire the weaker protections afforded investors, compared with corporations.

Rich Kinder did much to build the MLP model with Kinder Morgan (KMI) before breaking his “promises made, promises kept” pledge on distributions (see Kinder Morgan: Still Paying for Broken Promises). Five years later, income seeking investors have still not forgotten. David Dehaemers worked under Kinder at KMI, who was at Enron before that. A substantial portion of America’s energy infrastructure emerged from Enron’s energy business. Jeff Skilling’s record of broken promises persists.

TGE’s board has an opportunity to restore some trust, depending on how they respond to BX’s offer.

We are invested in ET, KMI and TGE

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).