MLPs: Five Years On, Cheaper Than Ever

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The end of August was the five year anniversary of the peak in MLPs. Had it not been for the distraction caused last week by a more compelling story (see Blackstone and Tallgrass Further Discredit the MLP Model), we would have already noted this milestone.

The Alerian MLP index, albeit much changed and diminished since August 2014, remains 38% lower including dividends. We won’t repeat the reasons, which are familiar to regular readers (see It’s the Distributions, Stupid!).

Pipeline stocks have certainly labored under some poor management decisions (see Kinder Morgan: Still Paying for Broken Promises) and self-dealing (see Why Energy Transfer Can’t Get Respect). However the Blackstone take-private offer for Tallgrass (TGE) plays out, this unfortunate episode has confirmed the wariness of many investors for the weak governance of publicly traded partnerships.

But the broad energy sector also languishes, now representing less than 4.5% of the S&P500. The S&P energy ETF (XLE) is 42% off its highs of June 2014. The Van Eck oil services ETF (OIH) is down a staggering 83%. The sustained weakness in the pipeline sector has to be considered against this backdrop. Even Exxon Mobil (XOM) is 25% off its April 2014 high, and yields over 5%. For the first time in the history of the S&P500, XOM is not in the top ten.

Energy investors are keenly aware that, although their sector bottomed in February 2016 along with crude oil, the broader equity market has risen over 50% from that low point. The S&P500 is within 2% of new all-time highs.

Holders of midstream energy infrastructure stocks are clearly not momentum investors. But they have identified relative value – the chart below highlights that relative P/Es compared with the S&P500 favor MLPs more clearly than during the financial crisis, or even the February 2016 low which capped an even bigger drop than in 2008-9.

MLP Valuation Discount to the SP500

P/Es rarely even figure in evaluations of MLPs, since earnings are often distorted by depreciation charges that don’t reflect the actual change in value of owned assets. So it’s notable that even using earnings numbers that are usually lower than Distributable Cash Flow (DCF), the sector is cheap.

In discussions with investors, we continue to find that growth in free cash flow is the strongest bullish case. The chart below (also see The Coming Pipeline Cash Gusher) is based on the American Energy Independence Index, which provides broad exposure to North American corporations along with a few large MLPs. Existing assets are generating increased DCF, and investment in new projects peaked last year. We revise these projections quarterly based on guidance during earnings calls, and so far the numbers are approximately tracking what we expected when we first projected FCF in April.

Pipeline Sector Free Cash Flow Soars

There can be few areas of investing as unloved as energy. Investors may be put off by past distribution cuts, poor capital allocation decisions, questionable governance or climate change (see  Our Fossil Fuel Future (With a Bit More Solar and Wind)).

In response: distributions are rising; growth capex has peaked; most of the sector is now corporations, with more robust governance; and serious long term forecasts recognize that fossil fuels will provide 80% or so of the world’s energy for decades to come.

Diverse Sources of Energy Needed

Valuations and growing cashflows support a recovery in prices.

We are invested in 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).

Blackstone and Tallgrass Further Discredit the MLP Model

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​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).

Private Equity Sees Value in Unloved Pipelines

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Last week the Financial Times wrote about the dwindling conviction of believers in the Shale Revolution (see Why US energy investors are experiencing a crisis of faith). Religion is an appropriate metaphor – secular values such as Enterprise Value to EBITDA or forward free cash flow yield have offered scant protection. To invest in energy today is to be a Christian thrown into Rome’s Coliseum.

In January Blackstone Infrastructure Partners (BIP), invested $3.3BN for a controlling interest in Tallgrass Energy (TGE) which, following a simplification of its GP/MLP structure left Blackstone owning 44% of the company. On Tuesday night TGE disclosed a take-private offer from BIP for the rest of TGE. It’s a measure of how poorly TGE’s stock has performed that buying the remaining 56% would cost $200MM less than BIP’s original investment even after the 35% premium embedded in the proposal.

The good news came with a sour taste. A previously agreed sideletter between BIP and TGE came to light revealing a sweetheart deal for management. In the event of a take-private transaction like this one, management can sell its shares at $26.25, not the $19.50 agreed for all the public investors. A cynic might conclude that TGE allowed uncertainty about their capex plans and recontracting on pipelines to weigh on the stock price, inviting BIP to acquire the balance below their earlier deal price while paying insiders 35% more. Energy sector executives provide ample material for critics who see scant evidence of a fiduciary mindset.

Returning to negative sentiment, retail investors struggle with the failure of growing oil and gas production to lift the prices of midstream energy infrastructure, with its toll-model supposedly fairly insulated from commodity prices. Public market valuations differ from where private equity sees things. It turns out  BIP is also puzzled but happy to exploit the opportunity.

They’re not the only private equity investor to have misjudged the depth of public market antipathy to energy. Last year Global Infrastructure Partners (GIP) invested $3.125BN to acquire a controlling interest in Enlink Midstream (ENLC). Following their GP/MLP simplification a few months later, GIP owned 40% of ENLC.

Today ENLC’s market cap has sunk to $3.6BN, creating a paper loss for GIP of almost $1.7BN. Former CEO Barry Davis returned, replacing Mike Garberding who had been promoted from CFO less than a year earlier. It’s not just retail investors who have bought into undervalued pipeline stocks too soon.

Earlier this year private equity firm IFM Investors bought Buckeye Partners for $6.5BN, a 32% premium to the market price.

Goldman Sachs recently noted that around $250BN in private equity “dry powder” is dedicated to infrastructure and natural resources. It won’t all find its way into the U.S. pipeline sector, but the American Energy Independence Index, which broadly reflects the sector, now has a market cap of around $450BN. The float-adjusted figure, removing shares held by management that don’t trade, is $372BN. GIP is raising a fourth fund targeting $17.5BN, undeterred by the paper loss GIP III has taken on ENLC.

Available Private Equity Capital

The end of August marked the five year anniversary of the peak in the Alerian MLP Index. It remains 39% off its high. Hinds Howard, who follows the sector for CBRE Clarion Securities, notes more than 80 constituents have been removed from the index. MLPs have steadily become less representative of midstream energy infrastructure. The Alerian MLP Index (AMZ) has a market cap of around $250BN ($150BN float-adjusted).

The FT article blamed the slump in part on poor spending discipline. By way of confirmation, PDC Energy’s (PDCE) recently announced acquisition of SRC Energy (SRCI) anticipates annual savings of $50MM in General and Administrative (G&A) expense. Considering SRC’s entire G&A was $39MM last year and the company’s market cap is $1.1BN, this is not a company with a parsimonious culture towards corporate overhead. Both stocks rose on the news.

Investors want further consolidation in the energy sector, including midstream. There are more senior energy executives than we need.

We are invested in ENLC 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).

Bond Buyers Should Buy Pipeline Stocks

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Yields on McDonalds’ Euro-denominated bonds recently joined European sovereign debt in negative territory. It’s a headline writers dream (juicy burgers, not yields…customers and investors pay to do business, etc).

$17TN in publicly traded debt now yields less than zero – 30% of the entire investment grade market. Debates rage about what this means. Bond investors are not accused of being analytically weak – something bad must be over the horizon. As mentioned before, we’re contemplating the idea that such a stubborn retention of fixed income investments reflects a degree of risk aversion towards stocks, for fear of a sharp fall. The searing memories of the financial crisis are within the careers of most market participants. Stocks are always vulnerable to a big sell off. But the preponderance of caution reflected in the scramble for low-risk yet yield-less bonds suggests speculative fever is not rampant. In this view, stocks are cheap.

The energy sector has provided unattractive risk/return of late. It’s why it’s so cheap. One of the reasons for poor sentiment could be climate change. 82% of the world’s energy comes from fossil fuels, and the average of serious 20-year forecasts sees this at around 80% in 2040. Reading articles on renewables can consume much of a day, every day, while those expecting the 82% share to stay roughly the same are a rare breed.

If equity valuations on midstream energy infrastructure stocks reflect a widespread belief that oil and gas pipelines will soon be as useful as a VHS recorder, bonds issued by these same companies should offer commensurately high yields.

But they don’t. A review of yields on the investment grade bonds of U.S. issuers in the American Energy Independence Index averages 3.7% (using the weights of the index). Although yields of any kind are hard to obtain nowadays, the 3.9% yield on 2054 bonds issued by Enterprise Products Partners (EPD) suggests a high expectation of being repaid in full. This in turn requires pipelines and related infrastructure to maintain their critical role in America’s energy supply for at least another four decades. EPD’s stock yields over 6%. Its distribution is growing and buybacks are likely. Try and conceive a scenario in which the holder of the 2054 bonds will, over any plausible investment horizon, do better than the equity investor.

Pipeline Stocks Dividends on Bond Yields

Kinder Morgan (KMI) has bonds maturing in 2098, in effect perpetual debt, yielding 5.1%. Although this is modestly higher than the stock’s 4.9% dividend yield, next year’s expected 25% hike will fix that. Although the 2098 bond issue is a tiny $26MM, they have $33BN outstanding, much falling due after 2040. The holders of KMI 2098 bonds no doubt congratulate themselves for doing better than investing in French energy giant Total (TOT), who recently issued perpetual Euro debt at 1.75% (see Blinded by the Bonds). But if they like KMI’s 80 year bonds, they’d have to prefer the equity.

The investment grade issuers in the table represent half of the American Energy Independence Index. Their long dated bonds yield 4.3% — profligate by today’s standards, but nonetheless too low to reflect anything other than confidence of full repayment over the decades ahead. The holders of these bonds must regard equity buyers as having abandoned all reason in allowing dividend yields to drift so high.

If fixed income buyers like midstream energy infrastructure, eventually equity buyers will find reason to follow.

We are invested in EPD and KMI.

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).

Canada Looks North to Export its Oil

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Infrastructure projects can require a lot of planning, but the proposed link by the Alaska – Alberta Railway Development Corporation (A2A Rail) traces its roots back to 1898, when a charter to build a line to Alaska was awarded to the Edmonton & District Railway Company. Canada is perennially challenged to move its bitumen-based crude oil to export markets. Progress on the Keystone XL suffered years of delays. It’s designed to move crude from Alberta to Cushing, OK. Environmental activist opposition under Obama at one point caused TC Pipelines (TRP, then called Transcanada) to take a C$2.9BN writedown in 2016.

The obvious move was Trans Mountain (TMX), an expansion pipeline within Canada to the Pacific coast for export. But this caused such acrimony between Alberta and neighboring province British Columbia that Kinder Morgan Canada eventually gave up, selling the project with fortuitous timing to the Canadian federal government.

Enbridge (ENB) recently told us they wouldn’t attempt to build a new oil pipeline in Canada, unless it was wholly within energy-friendly Alberta.

Against this backdrop, there’s a resurgence of interest in moving crude by rail to export facilities in Alaska. It’s a measure of the unintended consequences of environmental extremists that a higher-cost, riskier route is being pursued. Alberta’s oil production exceeded the takeaway infrastructure so significantly that the provincial government imposed production constraints. Last year the benchmark Western Canada Select (WCS) traded as much as $30 per barrel below the WTI benchmark, ruinous testimony to Canada’s domestic transport constraints. Getting its oil to markets has created fissures within Canada. Albertans feel their net contributions to the Federal budget are unappreciated by the rest of the country.

Few Canadians will soon forget the 2013 crude train disaster in Lac-Magentic, when a fireball engulfed a small town in Quebec, killing 47 people. Pipelines’ better safety record is ignored by opponents of today’s energy, hence reconsideration of the railroad.

The Alberta – Alaska Railway (A2A) will run from Edmonton and Fort McMurray, in the heart of Alberta’s tar sands region, carrying 1-1.5 million barrels a day of crude to the ports of Alaska’s south central coast. It’ll link up with the Trans Alaska Pipeline System, which accesses Alaska’s North Slope oil reserves. Proximity to Asian markets shaves four days off the shipping time compared with ports in the Gulf of Mexico, home to North America’s crude export terminals.

A2A Rail Route

A2A will pass through Canada’s Yukon territory, a remote and resource-rich area. Supporters note that extracting Yukon’s valuable minerals will become more commercially attractive with access to railroad transport. Flexibility is rail’s main advantage over the pipelines, which offer safe, specialized transport just for liquids and gas. Copper, lead, zinc and uranium could be mined and linked by an extension to the A2A, boosting local employment in a sparsely populated and relatively poor region. By promoting benefits beyond global access for Alberta’s crude, the project is aiming for broad support.

A2A may even provide alternative rail shipment for Asian goods coming into the U.S.

The cost is estimated at C$14-20BN, and should find eager investors among the many private equity funds dedicated to infrastructure. Robert Dove, Head of Financing and Strategy for A2A Rail, said, “We anticipate institutional investors will find the long term cash generating ability of the railway to be highly attractive. By providing improved access to export markets for Canadian crude oil as well as developing important mineral reserves in the Yukon Territory, we think there are multiple revenue opportunities for this important infrastructure project.”

In June, A2A Rail reached agreement with the Alaska Railroad Corporation on working together to build the connection. Stakeholder consultations come next, including negotiations with the many indigenous tribes known collectively as First Nations. In many cases opposition can probably be softened with community investments. 121 years after first being contemplated, a railroad from Alberta to Alaska took another step towards reality.

Although there seem to be countless stories about the demise of fossil fuels because of climate change, projects such as A2A reinforce that oil, gas and natural gas liquids will continue to provide the vast majority of the world’s energy for decades to come.

We are invested in ENB and TRP.

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).

Pipeline Earnings Confirm Positive Trends

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

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

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

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

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

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

The positives include:

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

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

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

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

SL Advisors is also the advisor to an ETF (USAIETF.com).

Natural Gas: The Big Energy Story

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The world’s energy sector is undergoing a transformation. Widespread press coverage of the growth in renewables reflects increasing concern about climate change. Nextera Energy, the world’s biggest producer of wind and energy power, epitomizes the excitement about clean energy (see Is Nextera Running in Place?). A recent investor day highlighted falling costs and growing demand in the move away from fossil fuels.

Opposition to new natural gas pipelines has led Con Ed in Westchester County to place a moratorium on new gas hookups. Berkeley, CA has banned natural gas in new buildings. Investors wonder how long fossil fuel demand will last.

But the numbers reveal that natural gas is the real revolution, with renewables having far less impact than press coverage suggests.

Last year, natural gas provided 43% of the growth in global energy use, versus 18% for renewables. In the U.S. renewables increased their market share from 3.9% to 4.2%, but natural consumption jumped 7X as much in absolute terms, taking market share from 29.2% to 31%. Oil, coal, nuclear and hydro power all suffered modest declines.

The U.S. figures relate to domestic consumption, but Chinese imports of Liquified Natural Gas (LNG) will provide further demand. China consumes more than half the world’s coal. Beijing’s smog is well-known, and domestic pollution has led the government to set ambitious goals for increased natural gas use. Chinese citizens are dying earlier and suffering respiratory illnesses because of coal pollution. The 13th Five Year Plan calls for natural gas to be 10% of China’s primary energy use by next year, and 15% by 2030. Last year natural gas was 7.5%. Although China can claim they are lowering their greenhouse gas emissions, they’re fighting domestic pollution not global climate change.

Since China’s energy use is growing, achieving their 2030 goal of 15% natural gas will require much more than simply doubling their existing consumption. Chinese energy demand is growing at 4.3% annually. At that rate, they’ll need 65% more energy than at present. Natural gas use will have to more than triple to reach their 15% goal by 2030.

China will need an additional 61 Billion Cubic feet per Day (BCF/D), approximately three quarters of current U.S. consumption. This is approximately the amount of new gas supply unleashed by the U.S. Shale Revolution. China’s current coal use is equivalent to around 200 BCF/D. There is enormous potential to substitute natural gas.

 

Russian gas from Eastern Siberia will be an important source of new supply, but China is also short of storage capacity. As in the U.S., demand peaks seasonally in summer and winter, but unlike the U.S. China has limited ability to build up reserves in the shoulder seasons. It’s also expected that the new Russian gas supply will have fairly inflexible volumes and won’t be able to vary production seasonally. These two factors are behind the expected jump in Chinese LNG imports over the next decade shown in the chart.

Even if Chinese LNG imports quadruple as in one forecast, China will fall far short of its goal to get just 15% of its energy from natural gas. If the Chinese are serious about combating pollution, they’ll want every feasible LNG export facility built.

 

If President Trump ran an energy company, he’d blame the liberal media for reporting fake news about the growing dominance of renewables. Solar and wind are an interesting story, and there’s no shortage of reporters covering their growth. But the figures show that profound change in the world’s energy markets is being driven by natural gas. It doesn’t receive commensurate press coverage, but it’s the big story.

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).

Is NextEra Running in Place?

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

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

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

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

NextEra Energy Projected Capital Expenditures

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

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

Strong Growth Projected in Renewables

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

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

Renewables Power Prices to Fall

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

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

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

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

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

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

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

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

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

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

SL Advisors is also the advisor to an ETF (USAIETF.com).

Reviewing Russell Gold’s The Boom

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Although Russell Gold’s The Boom: How Fracking Ignited the American Energy Revolution and Changed the World is now almost five years old, it still provides a relevant commentary on America’s Shale Revolution. Unlike many other chroniclers of America’s energy renaissance, Gold managed to obtain an invitation to see first-hand how drillers unlock hydrocarbons from shale. We already know it’s a noisy, dirty process that’s highly disruptive to the local community. But we also learn about the intersection of science with the brute force required to fracture the rock holding the commodity. Huge trucks carrying water and pump trucks converge on the drilling site. Inside the trailer where technicians control the process, “The computers, the headphones, and the focused faces make the van feel a bit like a NASA command center.” But they’re still oil sector workers, so better resemble a NASCAR pit crew working at NASA.

The Boom By Russell Gold

Gold highlights Shale’s huge benefits to the U.S. Oil companies have known for decades that impenetrable source rock held enormous reserves. Early efforts at fracturing it used high explosives, and in the 1960s there was serious discussion about using nuclear bombs. Between 1969 and 1973 several nuclear devices bigger than the one dropped on Hiroshima were detonated underground to release natural gas. Subsequent production wasn’t impressive, and poor economics as well as environmental concerns soon ended such efforts.

The author balances the positives with concerns about drilling’s local environmental impact, as well as the continued use of fossil fuels. He concludes that increasing natural gas use is the preferred outcome because it displaces far dirtier coal plants for electricity generation. In time, like many observers, he expects renewables to dominate, but that’s still likely decades away. Battery storage continues to be a significant hurdle to relying on intermittent sources of energy such as solar and wind. Bill Gates noted this in a recent blog, writing that, “…solar and wind are intermittent sources of energy, and we are unlikely to have super-cheap batteries anytime soon that would allow us to store sufficient energy for when the sun isn’t shining or the wind isn’t blowing.”

It turns out oil is a fantastically efficient form of energy storage. A memorable illustration comes from a speech by Steven Chu, former U.S. Energy Secretary under Obama. In comparing different materials for their energy density per unit of weight, or volume, he noted that, “The most efficient energy sources were diesel, gasoline and human body fat” (italics added). Apparently, an ample girth has energy storage capabilities to which battery developers aspire in their labs. Chu added that a battery holding a comparable amount of energy would require eighty times more space and weight. This was back in 2010, but today’s best batteries still don’t come close.

Gold identifies privately owned mineral rights as a crucial difference between America and the rest of the world. Although English Common Law underpins the U.S. legal system, sovereign ownership of what’s underground is one attribute that happily didn’t cross the Atlantic. The sharing of wealth with the community where drilling takes place is an important pillar of support. In 2014 when The Boom was published, fifteen million Americans lived within a mile of a well that had been fracked within the past few years. Today’s it’s certainly more. Although proximity produces supporters and opponents, generally fracking happens where it’s welcome, which is as it should be. Since Gold’s initial interest in the subject was due to Chesapeake buying drilling rights on his family’s farm, his perspective is well informed.

The rise and fall of Aubrey McLendon, late founder of Chesapeake, take up two chapters. McLendon was a colorful character who thought big and took the industry to higher gas production than would have happened without him. The Boom was published before McLendon’s fiery death in an automobile accident. It looked like suicide, occurring in March 2016 when the energy collapse was straining his high risk business strategy, but was later ruled accidental.

It’s also interesting to learn about the career of George Mitchell, often called the father of fracking. Mitchell’s persistence with unlocking shale reserves where others had given up is now industry legend.

The Boom deserves a place on the bookshelf of anybody interested in learning more about the Shale Revolution.

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

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).

Texas Reconsiders Flaring

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

natural-gas-flaring

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

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

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

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

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

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

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

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

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

We are invested in WMB.

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

SL Advisors is also the advisor to an ETF (USAIETF.com).

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