Wednesday’s report on crude oil stocks from the Energy Information Administration (EIA) showed a sharp jump in storage of 1 million barrels per day (MMB/D). Given the already fragile mood around tariffs slowing GDP growth, crude oil prices predictably slumped.

Interestingly though, over the past year the “Adjustment”, or fudge factor which is used to make the numbers add up, has grown substantially.

In simple terms, the EIA counts production, exports, imports, change in storage and refinery usage. This should pick up every barrel of oil moving through the U.S. It must frustrate the EIA’s number crunchers that the figures never foot, so they use a balancing item which used to be called “Unaccounted for Crude Oil”, nowadays simply the Adjustment. Since June 2018, the Adjustment has almost tripled.

Over the past year, crude oil used by U.S. refineries has been stable. Because much of America’s increased production is light crude from the Permian ill-suited to domestic refineries, imports have also remained unchanged. Higher exports have absorbed most of the increase in output.

The Adjustment exists solely because one of the other figures is wrong. So we’re refining more, exporting more, importing less, storing less or producing more than reported. Of these five different items, some should be easier to measure than others. The refinery figure seems unlikely to be far wrong; refineries must know what they’re using and there are 135 refineries in the U.S. from which to gather information.

Similarly, imports must surely be correct since the government licenses imports, and counting exports would also seem reasonably straightforward – the number of points of exports (cross-border pipelines and crude-loading export facilities) are known and not that numerous.

However, in reviewing the EIA’s methodology for calculating exports, they rely heavily on data from the U.S. Customs Border Protection (CBP) as well as figures from Statistics Canada (since exports to Canada don’t require a U.S. export license). The EIA runs the data through estimation models that they believe improve its accuracy. In some cases they’re using monthly data, even though their report is weekly.

There are many types of petroleum product beyond crude oil, including finished motor gasoline, kerosene, distillate and residual fuel oil among others. And the granting of an export license need not coincide with the physical shipment of the product. So it’s a more complex task than you might suppose.

Storage would also seem straightforward. Storage terminals are hard to miss. So the 967 thousand barrels per day (MB/D) build in storage ought to be reliable. Since the prior week saw a 41 MB/D decrease in storage, crude traders inferred softening demand.

But storage has its own complexity, since crude oil sitting on a tanker awaiting unloading is, in effect, floating storage. A possibility suggested by one sell-side firm is that floating storage was drawn down sharply. This presumes that several million barrels of crude was in tankers bobbing within U.S. territorial waters, already counted as imported but not yet unloaded. If true, this would mean the apparent jump in onshore storage was offset by a drawdown in floating storage, making the report far less bearish.

While this could explain the sudden, one-time shift in the storage figure, the Adjustment was the same last week, which undercuts the logic behind this explanation.

This brings us back to production, currently estimated at 12.4 MMB/D. Of the line items in the EIA’s report, it seems to us that this one is most plausibly the source of the growing Adjustment. There are around a million wells in the U.S. producing crude oil, from some decades old dribbling out a few barrels a day to new Permian wells producing 10 MB/D or more. We think it’s likely that the EIA is somehow undercounting crude oil output.

Flaring of associated natural gas in the Permian recently hit 661 million cubic feet per day (MMCF/D), up sharply from the previous high late last year of 450 MMCF/D. This reflects growing crude oil production. The continued shortage of take away infrastructure in the region to handle the natural gas that is extracted with the crude oil is why there’s more flaring.

Nobody really knows why the EIA’s weekly report includes an error term that is growing embarrassingly large. Robert Merriam, director of the office of petroleum and biofuels statistics at the EIA, admitted, “There’s something more systematic going on that our surveys aren’t capturing. We have some theories on what that may be and we’re trying to look into it.”

Undercounting crude oil production seems the most likely explanation. If so, this would reinforce a couple of important themes:

1) The U.S. continues to gain market share in world energy markets

2) Growing volumes even with moderate pricing defy those who argue that much of our shale activity is unprofitable

Oil and gas production continue to surprise to the upside, which can only be good for midstream energy infrastructure.

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).

A common concern of both existing and potential investors in energy infrastructure is the relatively high volatility of recent years. Many recall the “toll-model” of pipelines that was the basis of their appeal prior to 2014. As we have often written, the Shale Revolution broke the MLP model, as companies with very high payout ratios and hitherto minimal growth projects set about adding infrastructure. Oil in North Dakota, natural gas in Pennsylvania and increasing volumes of crude in west Texas required new investments (see It’s the Distributions, Stupid). The income-seeking investors originally attracted by high yields wound up in growth businesses that prioritized reducing leverage and funding projects over maintaining distributions.

Our theory is that this one-time alienation of the core investor base was highly disruptive and led to a period of heightened volatility. The shift in MLP business model from income generating to growth coincided with a sharp downturn in the energy sector. Investors worried about the profitability of upstream exploration and production companies showed similar concern over midstream. Even though EBITDA grew and leverage fell for pipeline stocks during this period, the sector moved with the energy sector.

There are signs that this period of heightened volatility is coming to a close. When energy markets bottomed in early 2016, the average daily percentage move of the Alerian MLP index reached almost 2.0X that of the S&P Energy Sector ETF (XLE). In late 2017 the ratio was briefly even higher. Since then, this relationship has improved dramatically in favor of these toll-like business models, falling by more than half and approaching the range that prevailed 7+ years ago.

This shift is even more dramatic than it seems, because the Alerian MLP index has been steadily losing components, rendering it less diversified and therefore more prone to sharp moves than it would otherwise be. Investors continue to exit mutual funds and ETFs tied to MLPs, as shown by the steady drop in shares outstanding for the Alerian MLP ETF.

Nonetheless, relative performance for the sector more broadly defined to include corporations has held up very well. The American Energy Independence Index (80% corporations and 20% MLPs, more reflective of the sector’s market cap of 2/3rds corporations) has retained its solid lead over the S&P500 this year, and is substantially ahead of XLE, especially following last week’s market weakness.

A plausible explanation is that, although retail investors are shunning MLP-only funds, institutional buyers are beginning to commit capital to pipeline corporations. Converting from MLPs to corporations was driven by a desire for a broader, more stable investor base. Although there are fewer MLPs remaining, they include conservatively run companies such as Enterprise Products Partners (EPD) and Magellan Midstream (MMP). There are some good MLPs to own.  However, some investors are starting to conclude that MLPs are too small a subset to command a sector allocation, and they’re more appropriate within a diversified portfolio that includes corporations.

The relative volatility of midstream infrastructure is reverting back to the lower levels that prevailed before the Shale Revolution triggered the need for large infrastructure investments. Moreover, free cash flow is set to jump over the next three years (see The Coming Pipeline Cash Gusher). This will continue to attract generalist investors interested in attractively valued stocks with declining volatility.

The pipeline sector is showing good momentum to continue its outperformance, driven by institutional buyers gradually replacing the retail holders of narrow, MLP-only funds.

We are invested in EPD and MMP. We are short AMLP.

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).

If Energy Transfer (ET) was a private company contemplating an IPO, the 15% Distributable Cash Flow (DCF) yield indicated by their underwriters would draw laughter. The bankers would be ushered out of the conference room.

Yet that is the lowly valuation investors assign to perhaps the least loved pipeline company in a sector that investors find lukewarm at best. ET is priced far below where they’d take the company public, if it wasn’t already a listed company. CEO Kelcy Warren and his team continue to execute and beat expectations on earnings. Last August Kelcy joked that, “A monkey could make money in this business right now.” (see Running Pipelines is Easy). Inviting critics to find fault, they nonetheless still deliver good results. Unlike most MLPs, ET (legacy Energy Transfer Equity) has never cut its distribution.

The market prefers style over substance, for on the soft issues of PR and Investor Relations (IR), ET’s record is sharply at odds with their financial performance. From their ill-fated pursuit of Williams Companies (WMB), the dubious dilution of shareholders with management-only convertible preferreds (see Will Energy Transfer Act with Integrity?) and the optically poor dispute over the Dakota Access Pipeline, this is a company that cares little about its image. Pennsylvania’s huge natural gas boom has been helped by a generally pro-energy regulatory regime, but ET has even managed to make enemies there.

ET’s PR staff must get combat pay.

Warren Buffett recently explained how Berkshire’s (BRK) $10BN investment in Occidental (OXY) was negotiated with no contingencies (save that they acquire Anadarko). Buffett needs to trust his investment partners. On this basis, ET is an implausible candidate for a BRK investment.

On the 1Q19 earnings call, Kelcy commented on how he is listening to the market. He’s been, “…trying to understand what the market would like to see us to do. What causes our unit price to perform better, in other words.”

Our advice would be start behaving like the kind of company that would interest Buffett.

ET’s 1Q19 earnings included EBITDA of $2.8BN and distribution coverage was ample at 2.07X. This exceeded expectations, although the 8% yield suggests some fear a cut. They guided to $10.7BN in 2019 adjusted EBITDA. ET’s stock had weakened over the prior month, so expectations weren’t high. Nonetheless, on the day following earnings ET slumped 1.3%, twice the drop in the broad-based American Energy Independence Index.

Kelcy Warren might compare ET with another big pipeline company, Plains All American (PAGP). If ET has delivered consistently good operating results distorted by a bad corporate image, PAGP has done the opposite. Their distribution relied unwisely on a volatile business segment (Supply and Logistics, S&L) whose arbitrage margins virtually disappeared from 2013 to 2017. The narrative accompanying results changed from “it’s skill not luck” to “forces out of our control”. The 2016 sweetheart “One and Done” preferred deal to shore up finances was anything but.

PAGP’s 2017 acquisition of the Alpha Crude Connector was ill-advised, and along with other growth projects exposed too-high leverage when margins fell. As a result, investors in PAGP subsequently suffered two distribution cuts.  Back in 2010 when the shale oil boom was in its infancy, PAA yield seeking investors received $3.75/unit in distributions.  In 2018 they received just $1.20 per unit.  It’s why income-seeking investors often feel so betrayed by MLPs. Nonetheless, the market has not punished PAGP’s stock as much as ET’s, although it’s also cheap. Former CEO Greg Armstrong’s folksy style created sufficient goodwill among investors that PAGP has a distribution yield a third less than ET’s. Their DCF and free cash flow are growing, but not as fast as at ET.

PAGP’s 1Q19 results were also good, buoyed by their resurgent S&L segment. Their 10% DCF yield reflects some concern that past mistakes will be repeated, and arbitrage margins are hard to forecast because they rely on shortages of pipeline capacity which can be fleeting. But their IR people at least have a more positive corporate image against which to tell their story.

As if to punctuate attractive valuations, on Friday Buckeye (BPL) was acquired at a 32% premium to its recent average price. BPL’s foray into international storage terminals led to chronic underperformance in recent years that even the buyout hasn’t rectified. They have mismanaged themselves into a takeover, at pricing substantially higher than ET’s.

Both ET and PAGP are cheap. They each possess skills that would benefit the other. ET’s rebarbative management style contrasts with their efficient execution and strategic foresight, an area where PAGP needs to regain credibility after mis-steps in recent years. ET walks the walk, and PAGP talks the talk.

If each company can improve its weaknesses, they’ll continue to draw investors to an extremely cheap sector offering substantial growth.

We are invested in BRK, ET, PAGP, 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).

We’re in the middle of earnings season, and last week several companies provided 1Q reports. The energy sector continues to struggle to excite investors. Although pipelines stocks delivered very strong performance through March, in recent weeks investors have started to question the rally’s resilience.

As a result, sentiment could use a boost from strong earnings. Of the companies we follow, results so far have been at or ahead of expectations. Enterprise Products Partners (EPD) generated almost $2BN in EBITDA during 1Q19, handily beating forecasts. On the earnings call they discussed the conversion of their Seminole pipeline to carry crude oil instead of Natural Gas Liquids (NGL) from the Permian to Mount Belvieu: “…given its location and interconnects, we will always have flexibility to convert this pipeline back to NGL service depending on the pipeline supply demand balances for crude oil and NGLs in the future. I doubt that anyone else will be able to offer this type of future flexibility to Permian producers and to markets.” We get some questions about the likelihood of excess pipeline capacity in the Permian, and this optionality is useful.

There was another interesting exchange on propane exports, where EPD conceded to a drop in market share from 80% to around 50%. They’ve concluded that their pricing was too high, and plan to be more competitive. Energy Transfer (ET) CEO Kelcy Warren complained on their fourth quarter call about spending to protect his turf from competition from fringe private equity projects.  EPD shares the same distaste for new, greenfield projects competing with more economic brownfield expansions on their existing footprint. EPD CEO Jim Teague commented that, “…we’re not going to make the mistake of having prices that (and) invite more competition.”

Takeaway infrastructure for Permian crude production often comes with associated natural gas. Inadequate takeaway infrastructure has led to flaring, and recently pushed prices at the Waha hub collection point negative. On April 3^rd, some Exploration and Production (E&P) companies paid $9 per MCF to dispose of natural gas.  Forward price remain negative through 2021.  The crude oil that they’re seeking is sufficiently profitable to cover this additional overhead. Under the circumstances, one might think E&P companies would be pushing for additional natural gas takeaway infrastructure. However, Williams Companies (WMB) CEO Alan Armstrong reported that few were willing to commit volumes on terms to support such an investment.

Earnings reported so far support our free cash flow bridge below, first published last week.

WMB earnings were in-line with expectations, and their 2019 growth capex guidance was lowered by $200MM to a range of $2.3BN to $2.5BN.

Capex guidance was generally among the more keenly examined numbers, given past years’ focus on growth projects. Last week we noted that such investment peaked last year, which is supporting growing free cash flow (see The Coming Pipeline Cash Gusher).

Oneok (OKE) logged 12% year-on-year distribution growth, with Distributable Cash Flow (DCF) providing 1.43X coverage while continuing to advance key projects on schedule. Lower payout ratios are the new normal, to provide more flexibility and reduced need to issue equity.

Enlink (ENLC) disappointed with lowered guidance for 2019 natural gas output from Oklahoma, although their overall report was within expectations. Its 14% DCF yield is very attractive and we like the management team.

Crestwood (CEQP) raised 2019 EBITDA and DCF guidance with continued strength from their Bakken assets,and expects 20% DCF growth through next year. Their 13% DCF yield seems unreasonably high.

Western Gas (WES) reported 7% annual distribution growth, but the competition to buy parent Anadarko (APC) will dominate their performance until it’s resolved.

With Occidental (OXY) outbidding Chevron (CVX) for APC, many are surprised that the consolidation and implied vote of confidence in shale from a major oil company isn’t drawing in more support for the energy sector. Berkshire’s (BRK) proposed $10BN investment in OXY via 8% preferred securities with warrants for 80 million shares at an exercise price of $62.50 represents either (a) a valuable endorsement of growing U.S. oil production, or (b) proof of the high cost of capital facing a still unloved energy sector. Whichever it is, the APC M&A saga can surely only be good for midstream energy infrastructure.

More earnings reports are due next week. So far, what we’ve seen is increased capital discipline, lower leverage, growing cash flows and higher coverage ratios. This is consistent with our overall, constructive outlook for the sector.

We are invested in BRK, CEQP, EPD, ENLC, ET, OKE, WES 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).

The Shale Revolution has certainly provided America with more geopolitical freedom. The 1973 Arab oil embargo punished the U.S. for supporting Israel, as it fought Egypt and Syria. Shortages of gasoline visibly demonstrated the limits to U.S. actions. As a result, every president since Nixon has called for energy independence.

Swaggering energy dominance is the new goal, since independence has, by some measures, already been achieved. But reduced dependence on imports doesn’t bring immunity from price spikes, given that oil is a global commodity easily moved to the most eager buyer.

A benefit of investing in midstream energy infrastructure that we rarely hype is its domesticity. There are pipelines all over the world, but we stick to North America where property rights and rule of law are secure. Weakness in, say, the Turkish lira is of no concern.

Energy markets today are sanguine, in that there is little risk of disruption priced in. Meanwhile, global crude oil demand is growing at around 1.5 Million Barrels per Day (MMB/D). Saudi Aramco’s recent bond offering disclosed production capacity that’s more limited than many had thought.

Venezuela’s output continues to collapse, with U.S. sanctions kicking a chronically mis-managed economy already on its knees. Libya is on the verge of civil war, placing more output at risk. And now the waivers on Iranian exports are about to be cancelled, with the U.S. stated goal of reducing their oil exports to zero.

The 1941 U.S. embargo on Japanese imports of oil and gasoline products led within six months to Pearl Harbor. Today’s Iranian sanctions are similarly intended to heap more pressure on the regime. U.S. warships patrol the Strait of Hormuz, assuring the flow of oil from Iran’s neighbors. Conflict is not inevitable and is hardly a viable proposition for Iran’s leaders. Economic pressure may yet induce Iranian change in policy, or even regime. That’s clearly our goal. But a miscalculation, or the conclusion that no good options remain, are possible.

In The Absent Superpower, Peter Zeihan’s book on the shifting gepolitical balance caused by U.S. shale, he notes, “Iran has a phalanx of varied missile systems that could reach any point within the strait itself, with many of them capable of reaching the Saudi shoreline even across the wider points of the Persian Gulf.”

Militarily there’s no doubt about the winner, but oil supplies could still be disrupted. A third of global seaborne crude passes through the Strait of Hormuz. In addition, Qatari exports of Liquified Natural Gas (LNG) account for a third of global LNG trade, with Kuwait importing LNG that travels north through the Strait.

Brent crude exhibits modest backwardation, of around $4 per barrel between June ’19 and June ’20 futures. Conflict with Iran would surely provoke a much bigger jump.

Energy has sunk to around 5% of the S&P500. It’s one of the few sectors (along with Defense) likely to perform well if U.S. military action occurs. Energy stocks, like crude oil, reflect little price premium for geopolitical uncertainty. Through last year pipeline stocks were sufficiently out of favor that their correlation with the S&P500 was sometimes negative. That’s just the relationship a hedge needs with its target portfolio.

Investors who are concerned about increasing geopolitical risks should overweight midstream energy infrastructure. It’s cheap, immune to war damage and provides good protection against Middle East conflict.

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).