Canadian Pipelines Lead The Way

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Sentiment among energy investors remains poor. The S&P E&P ETF (XOP) is -21% for the year. Energy has sunk to 4% of the S&P500. The Alerian MLP Infrastructure index (AMZIX) is -3% YTD and reached a low of 44% off its August 2014 high last week. This contrasts with the S&P500, which is +26% for the year. MLP tax loss selling has caused further downward pressure, since so many investors have realized gains in other sectors to pair against energy losses.

Although energy has been weak, wide performance divergences exist. Midstream energy infrastructure has done far better than the E&P companies that are its principal customers. Within that, pipeline corporations have done better than MLPs, which continue to suffer from erosion of interest among their traditional income-seeking investor base. Canadian corporations are among the best performers. TC Energy (TRP, formerly Transcanada), is +50% for the year including dividends, even handily beating the S&P500 with its 26% gain.  Few investors in midstream energy infrastructure realize how well TRP has performed, unless they own it. Enbridge (ENB), North America’s biggest midstream energy infrastructure company and also Canadian, is +31%. Pembina (PBA), a less well known Canadian pipeline company, is +27%.

Like their banks, Canadians pipeline companies tend to be run more conservatively. Over the past five years they’ve also set themselves apart from the rest of the sector. Their U.S. cousins would do well to adopt some of their disciplined capital allocation and prudent management practices. These three companies represent 55% of the 2019 Free Cash Flow (FCF) we project for the industry. Their performance supports the case that growing FCF leads to a higher stock price (see The Coming Pipeline Cash Gusher).

The Alerian MLP ETF (AMLP) is a rich source of opprobrium on this blog, because of its flawed tax structure (see MLP Funds Made for Uncle Sam). It does retain one useful feature though, in that it’s relatively easy to short. Big pipeline companies are under-represented in the Alerian index, because most of them are not MLPs. So AMZIX is stuffed full of what investors don’t want.  AMLP follows AMZIX, albeit from a distance. Because of its structure, since inception performance of 1.6% is only half its benchmark of 3.2%. AMLP is the worst performing passive index fund in history. This year AMZIX is 15% behind the investable American Energy Independence Index (AEITR), which is 80% corporations, including the abovementioned Canadians.

Comparing the two indices, one can see the recent sharp divergence in performance, which was probably exacerbated by tax-loss selling of MLPs. Short AMLP and long an AEITR-linked security has been a profitable trade. AMLP’s tax drag hurts in a rising market, where its flawed structure impedes its ability to appreciate with its underlying portfolio. But recent weakness has been led by the MLPs that predominate in AMLP, highlighting the importance of being in the right kinds of companies in this sector. Investors are favoring well-run Canadian pipeline corporations and shunning MLPs.

The Canadian pipelines offer powerful evidence that it’s possible to generate steady returns in this business. Those U.S. companies that perform well over the next couple of years will do so by adopting more of their culture from north of the border. Assuming FCF grows as we expect across the sector, performance of the Canadian stocks suggests positive returns should follow.

We are invested in ENB, PBA and TRP. We are short AMLP

We manage an ETF which tracks the American Energy Independence Index

Should Closed End Funds Use Leverage?

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Closed end funds (CEFs) are an obscure sector of the market with a small but fiercely passionate following. Because they have a fixed share count, they can trade at a premium or discount to the value of their holdings, which are usually public equities or debt.  This creates appealing opportunities to buy at a discount to intrinsic value. Closed End Fund Advisors provides a lot of useful information on the sector.

Liquidity is always a problem, so the investors tend to be retail with a small handful of institutions. It can sometimes take several days to get into or out of positions. We occasionally run across financial advisors who invest in CEFs for their clients.

In theory, CEFs should generally trade at a discount to Net Asset Value (NAV), because of their relative illiquidity compared to the basket of underlying shares. MLP CEFS have an especially interesting history. We often note the terrible tax structure of the Alerian MLP ETF, AMLP (see MLP Funds Made for Uncle Sam). But MLP CEFS pre-date AMLP and provided some justification for its launch.

This is because for many years MLP CEFs consistently traded at a premium to NAV. The Kayne Anderson MLP/Midstream Investment Company (KYN) illustrates this point. For most of its history, KYN shares have traded at least 5% higher than NAV and at times over 30%. MLP CEFs possess the same tax inefficiencies as AMLP, in that they are liable for corporate taxes because they are more than 25% invested in MLPs.

The benefit of the tax drag is that KYN investors get exposure to MLPs without the tax hassle of K-1s for tax reporting. A decade ago, investors clearly placed a high value on this simplified tax reporting, as evidenced by the substantial premium to NAV at which KYN traded. AMLP’s 2010 launch took place against this backdrop of strong demand for the tax-burdened, 1099 structure.

Where KYN and other MLP CEFs differ from AMLP is in their use of leverage. This is common in CEFs and supports higher yields in exchange for increased NAV volatility. In addition, the interest expense lowers taxable income, which can lower the inherent inefficiency of an MLP CEF with its corporate tax obligation.

For the past year, KYN has traded at a discount to NAV averaging almost 10%. It’s another symptom of declining retail interest in the sector. The sharp 2014-16 drop with heightened volatility caused some damage.

It’s worth revisiting the use of leverage by MLP CEFs. To continue with KYN, in reviewing their past financials, they seek to stay close to “400% debt coverage”, meaning that their desired portfolio consists of $400 in investments funded with $100MM in debt and $300MM in equity. So $1 invested in KYN controls $1.33 in MLPs. The 400% debt coverage rises and falls with the market. Rebalancing back to their target requires selling after a market drop, and buying following a rally (i.e. buy high, sell low). KYN tends to move a little more than the market as a result.

The question is, whether such leverage continues to make sense. MLP balance sheets have come under a great deal of scrutiny in recent years. The industry has moved towards self-funding growth projects with less reliance on external financing; higher distribution coverage; less leverage. Investment grade companies now target around 4X Debt:EBITDA.

A portfolio of MLPs is pretty concentrated. An investor in KYN or other MLP CEF, by accepting leverage at the CEF level, is implicitly rejecting the industry’s 4X Debt:EBITDA target as needlessly conservative. Is this a smart decision? It might make sense to add leverage to a diversified portfolio, because the low correlations across pairs of individual names will keep the portfolio’s volatility below that of its average holding. But if you’re invested in a single sector, the average volatility of the holdings will come close to your portfolio’s volatility. Adding leverage to that portfolio increasingly looks like adding more debt to each individual holding. The practical result is that the investor is adding more risk than the company and credit rating agencies deem appropriate.

We don’t use leverage in our business. The sector has been volatile enough in recent years, and the periodic rebalancings that are required tend to force you to buy high/sell low.

In KYN’s most recent quarterly financials (August 31), they noted 401% debt coverage versus their target of 400%. Since August, the Alerian MLP index (AMZX) has dropped 10%, implying KYN’s coverage ratio has sunk to 360%. Restoring their 400% target coverage will have required selling over $110MM in securities, adding to the market’s recent selling pressure. Last year’s 4Q saw a 17% drop in AMZX which was almost certainly exacerbated by MLP CEFs delevering. The rebound earlier in the year would have seen MLP CEFs similarly increasing leverage back up.

MLP CEFs are constantly chasing the market to restore their desired leverage. Higher volatility increases the cost of such frequent portfolio rebalancings. We think it’s time their investors reassessed whether accessing the sector with leverage makes sense.

We have three funds that seek to profit from this environment:

Energy Mutual Fund Energy ETF Real Assets Fund

 

Leverage Wipes Out Investor’s Bet on Enlink

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Managers of client capital invested in midstream energy infrastructure have had to explain recent weak performance to investors frustrated at missing out on the buoyant S&P500. We summarized the many conversations we’ve had last week (see When Will MLPs Recover?). The sector is up this year, although investors in MLP-only products like the Alerian MLP ETF (AMLP) are lagging the stock market by 25%, and pipeline corporations by 14%.

Energy remains out of favor to be sure, but midstream energy infrastructure bankruptcies remain rare. As much as fund outflows have pushed equity valuations to levels indicating financial stress, bond investors don’t share the angst. Long term investment grade debt in many cases yields less than the dividend on a company’s common equity.

If schadenfreude is your thing, consider the portfolio managers of Global Infrastructure Partners’ (GIP) GIP III fund. In July of last year, they invested $3.125BN into Enlink Midstream LLC (ENLC) and Enlink Midstream Partners, LP (ENLK). Following a simplification a few months later, GIP III wound up with 46.1% of ENLC, the surviving entity, and control of the managing member. $1BN of the $3.125BN was funded with a term loan, because private equity investors always add debt to juice their returns. So GIP III invested $2.125MM of equity.

We don’t use leverage ourselves. Midstream energy infrastructure businesses already operate with leverage that credit rating agencies assess in setting their credit ratings. To add borrowings on top is to reject the agencies as needlessly pessimistic. GIP III wanted a little more upside.

ENLC’s entire market capitalization is currently $2.6BN, valuing GIP III’s 46% stake at $1.22BN. After the $1BN term loan, GIP III’s $2.125BN equity investment is worth $225MM. On a mark-to-market basis, they’re down around 90%. Losing that much that quickly, even in this sector, is stunning. It shows that the most sophisticated institutional investors can get it spectacularly wrong. Few, including us, thought ENLC could sink this low. Its dividend yield is now 20%

GIP has built a strong reputation investing in infrastructure. They manage $51BN across various portfolios (or perhaps more correctly, now $49BN after adjusting for ENLC). They raised the funds for GIP III on the basis of their past track record. They even highlighted their ENLC investment in the marketing materials for the next fund, GIP IV.

Of course there’s no gain in someone else’s losses – but ENLC investors need to consider what GIP will do. Private equity firms generally avoid holding publicly traded securities – the constantly fluctuating valuations add unwanted NAV volatility.

Included in the list of Risk Factors in ENLC’s 2018 10K is:

“GIP has pledged all of the equity interests that it owns in ENLC and ENLC’s managing member to GIP’s lenders under its credit facility. A default under GIP’s credit facility could result in a change of control of the Managing Member.”

The paragraph goes on to explain that, “…if a default under such credit facility were to occur, the lenders could foreclose on the pledged equity interests.”

So the lender could, in theory, seize GIP III’s equity stake in ENLC and sell it to pay back the loan. It’s likely that whatever loan covenants were attached have already been breached, and in the apparent absence of any large sale of ENLC stock, one must assume that a renegotiation has taken place.

On ENLC’s recent earnings call, James Carreker of US Capital Advisors pursued a line of questions relating to GIP’s term loan, noting the reference to it in ENLC’s Risk Factors section of its 10K. CFO Eric Batchelder refused to comment, and offered to “…talk about it offline.”

GIP’s intentions with respect to its ENLC stake are a material consideration for the other investors. ENLC’s 10K warns that, “our operating agreement limits the liability of, and eliminates and replaces the fiduciary duties that would otherwise be owed by, the Managing Member and also restricts the remedies available to our unitholders for actions that, without the provisions of the operating agreement, might constitute breaches of fiduciary duty.” Although ENLC is an LLC, like other publicly traded partnerships in this sector it provides weak investor protections.

The 10K  goes on to point out: “Our operating agreement contains provisions that eliminate and replace the fiduciary standards that the Managing Member would otherwise be held to by state fiduciary duty law.”  Further on: “…whether or not to seek the approval of the conflicts committee of the board of directors of the Managing Member, or the unitholders, or neither, of any conflicted transaction.”

ENLC’s operating agreement gives GIP an extreme asymmetric position over public holders through its role as managing member. It may have backfired on them. This blog regularly chronicles management self-dealing (see Blackstone and Tallgrass Discredit the MLP Model for example). Growing concerns of abuse and unethical (if legal) behavior have likely caused generalist investors to avoid ENLC, because of GIP’s power to similarly exploit other investors. GIP’s selective rights and canceled obligations have probably hurt ENLC’s stock price.

Given the substantial drop in ENLC since GIP III’s investment, you might think acquiring the rest of the company would be compelling. GIP III likely doesn’t have the ability, and because the different pools of capital managed by GIP have different investors, there would be inevitable conflict of interest concerns if, say, GIP IV bought the balance. It could be perceived that one fund was bailing out another’s poor investment decision. Private equity has to deal with that issue all the time though, and it’s likely they could find a solution. It’s similar to the conflicts committees that usually rubber stamp MLP decisions on capital allocation.

There’s probably a strong motivation for GIP to resolve this issue by year’s end, when GIP III’s annual financials will include ENLC’s public stock price performance. You can be sure they’re pondering their options right now.

We are invested in ENLC and TGE

When Will MLPs Recover?

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Our blog topics are often informed by the subjects that come up in conversations with clients. October was a wrenching month, with the Alerian MLP index slumping to -6% versus +2% for the S&P500. MLPs have lagged equities by an astonishing 22% YTD. Over the last couple of weeks we have been busier than usual fielding calls from investors. By far the most common question in various forms is, when will MLPs recover?

So, for the benefit of those with whom we haven’t recently chatted but are wondering the same thing, below we summarize our thoughts:

  • Energy sector sentiment. This remains terrible. Investors would still prefer more disciplined capital allocation. Management teams too often seek dilutive growth, often because their compensation isn’t aligned with per-share metrics.
    Midstream energy infrastructure has handily outperformed the E&P sector this year, and capital discipline is improving. But many of the people we talk to are weary, looking for reasons to remain invested and searching for confirmation in their original investment thesis that increasing production should benefit pipelines with their toll-like model. However, there are positive signs here, in that Free Cash Flow for midstream energy infrastructure is set to soar over the next couple of years (see The Coming Pipeline Cash Gusher). Growth capex peaked last year, and existing assets are generating more cash. These are both driving FCF to almost $10BN this year, $27BN next year and $43BN or so in 2021. Recent quarterly earnings generally provided confirmation of this positive trend. For example, Targa Resources (TRGP), one of the worst offenders, has 2020 investment spending plans of $1.2BN, half of this year’s. Former CEO Joe Bob Perkins flippantly talked about new projects as “capital blessings”. Investors won’t miss his self-serving arrogance.
  • Retail investors are selling. Approximately $3.6BN, roughly 7% of the total, has left MLP mutual funds, ETFs and related products in the past twelve months, which creates constant downward pressure on prices. Although our own products have seen net inflows this year, this is not the norm.
  • The MLP business model is probably dead. Pre-2012, pipeline companies organized as MLPs and paid out 90% or more of their cashflow. Back then, America obtained its oil and gas from roughly the same places in the same amounts year after year. Few new pipeline projects were needed, so with little need to retain cash MLPs offered high yields. These attracted income-seeking investors who, because of the K-1s that MLPs issue, tended to be wealthy. In other words, old, rich Americans. The Shale Revolution offered up oil and gas in places not traditionally served by infrastructure – for example, the Bakken in North Dakota and the Marcellus in Pennsylvania. The Permian in west Texas, although long a producing region, saw significant increases in volume. MLPs decided to invest in new pipelines, pressuring balance sheets and ultimately sacrificing distributions. Kinder Morgan was the first to slash its payout, before ultimately simplifying its structure as Kinder Morgan Inc (KMI) absorbed the assets of its MLP, Kinder Morgan Partners (KMP). The rationale for becoming a corporation was to access capital from the world’s institutional equity investors rather than just the old, rich Americans who buy MLPs (see Kinder Morgan: Still Paying for Broken Promises). Most institutions avoid publicly traded partnerships because of complex tax considerations. In the process, original KMP investors, who had invested for stable tax-deferred income, suffered two distribution cuts and a taxable transaction when their units were swapped for shares in KMI. Many thousands remain bitter to this day.  Rich Kinder’s promise of ever rising distributions fueled higher payouts back to his general partner via Incentive Distribution Rights (IDRs).
  • Prior to 2014, many investors viewed the distribution as sacred and assumed that Rich would honor his promise to continue paying them.  After realizing they’d been duped into essentially transferring their money to Rich Kinder through this IDR mechanism based on broken promises, they’ve understandably become disillusioned.  If you run into a former KMP investor, ask about their betrayal by Rich Kinder. It’ll be a colorful story.  Other MLPs followed KMI’s lead. MLPs shed their income seeking investor base in their desire to fund growth projects. More distribution cuts and unwelcome tax bills followed. This transition to institutional, total return investors has been far harder than they assumed. The legacy of betrayal continues to hang over the sector. KMI had a slide titled “Promises Made, Promises Kept”, boasting about their 13 years of distribution growth.
    The Alerian MLP ETF has cut its distributions by a third, reflecting similar cuts by its underlying components. This is the only time we’re aware of in which companies slashed distributions even while operating performance was fine, as shown by the growing EBITDA on the slide below.
    EBITDA vs Leverage
    But if you’ve invested for the income and it’s cut, you’re let down and no mitigating circumstances will compensate. It’s why MLPs have shrunk to well under half the midstream energy infrastructure sector, with conventional corporations (“c-corps”) now dominant.
    Investors in MLP funds or MLP-only portfolios can select from a couple of big MLPs and many very small ones while overlooking six of the ten biggest pipeline companies, since they’re corporations. AMLP, with its 100% MLP construction and disastrous tax structure, would never be created in today’s form. It is a slowly shrinking legacy to the past (see MLP Funds Made for Uncle Sam).
  • Election year concerns. A Warren victory is perceived as the most negative, due to her proposed ban on fracking. If applied to federal lands this would have some very modest impact on production. Most drilling takes place on private lands and is regulated by the states. An outright ban on fracking would require an act of Congress which, barring a complete Democrat sweep to include control of the senate, we believe is highly unlikely.
  • Tax loss selling. This seems to happen every year, but energy’s chronic underperformance has created opportunities for investors to pair gains elsewhere with losses in this sector.
  • Climate Change. It’s hard to assess the impact of investors who might otherwise invest in energy declining to do so, either for ESG reasons or because they fear public policy will impose harsh limits on use of fossil fuels. ESG funds are notable investors in some of the biggest pipeline corporations but not in MLPs because governance (the “G” in ESG) provides weaker investor protections. Tallgrass recently demonstrated this (see Blackstone and Tallgrass Further Discredit the MLP Model). The result has been that the MLP-dominated Alerian MLP index has increasingly lagged our own American Energy Independence Index, which is 80% corporations.

Our best bet is that tax loss selling will soon abate, and continuing evidence of capital discipline will draw generalist investors to invest. There’s certainly plenty of interest from other buyers (see Private Equity Sees Value in Unloved Pipelines). But the history of distribution cuts, some poor capital allocation decisions and episodes of investor abuse because of weak MLP governance have depressed sentiment for some time.

For many years November was the best time to buy, with the predominantly retail investor base making the January effect more pronounced than in the broader equity market. The effect has become more muted as companies have switched from MLP to corporation, but still remains a factor (see Give Your Loved One an MLP This Holiday Season) 

We are invested in KMI and TGE

Tallgrass Responds to Critics, Missing the Point

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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.

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).

California’s Altruistic Carbon Policy

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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.

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.

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.

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.

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.

Drilling Down on Shale Depletion Rates

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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.

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.

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).

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.

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

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).

Unicorns Not Working

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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.

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.

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.

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.

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.

 

Pipeline Stocks Are Quietly Recovering

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“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.

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.

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.

 

Pipeline Earnings in a Market Focused Elsewhere

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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)

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.

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