Energy Infrastructure Needs a Catalyst

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Last week we spent a couple of days with Catalyst Funds at their annual sales conference in Clearwater, FL. The second winter storm in a week conveniently hit the northeast after everyone had flown south, so travel plans were not disrupted. Catalyst CEO Jerry Szilagyi has been a great partner for our MLP mutual fund, and we were asked to host eight roundtable discussions with the wholesalers who market it. We have developed many great relationships with them over the years, and it was very helpful both to update them on the sector as well as to hear their feedback. Through the Catalyst network, thousands of financial advisors and other investors have become clients. As many people know, I invariably enjoy our interactions with the people whose money we invest.

Many of our financial advisor clients will be meeting with Catalyst wholesalers in the weeks ahead, and we thought it would be useful to summarize our discussions, since they’re hopefully of broader interest. Energy infrastructure investors are frustrated that record production of U.S. crude oil, natural gas and natural gas liquids is failing to boost the sector. Bad news is bad and good news doesn’t seem to help. Sector performance was the most important conversation topic.

We think the explanation lies in the split of cashflows between investor returns and new projects. This is an issue for the energy sector overall, and not just energy infrastructure companies. Complaints have been loud that too much cash is plowed back into the business, with not enough earmarked for a return on capital to investors. For the past couple of years, net share repurchases by the S&P Energy Sector have hovered at less than 1% of market capital, the worst of any of the 11 S&P 500 sectors. When combined with dividends, at 3.45% the Energy sector yield (Dividends + Buybacks) is the lowest it’s been in a decade and a little more than half of what it was three years ago.

The redirection of cashflow towards growth projects is therefore not unique to energy infrastructure. As we noted last week (see Will MLP Distribution Cuts Pay Off?), dividends on investment products linked to the Alerian MLP Index are down 30% since 2014, while the index itself is 38% off its peak. Energy managements need to show that the cash they’ve redirected has been invested wisely. For now, any new growth initiative generally receives a big thumbs down from investors.

A consequence of the need for growth capital has been the decreasing relevance of the MLP model for energy infrastructure. The two are no longer synonymous, with MLPs representing less than half of the sector. Investors seeking exposure to the infrastructure supporting American Energy Independence need to look beyond MLPs.

MLPs are valued as if the 30% in distribution cuts is gone forever, whereas in many cases CEOs have justified it as financing attractive projects. A commensurate increase in Free Cash Flow (FCF) over the next couple of years would provide some vindication of those decisions. The market is waiting to see evidence. We have calculated that 15% annual FCF growth across a broad swathe of energy infrastructure corporations and MLPs (as represented by the American Energy Independence Index) is likely. As evidence of that starts to show up, it should be the catalyst the sector needs to rebound.

The other important topic concerned opportunities to upgrade portfolios for investors who are already in energy infrastructure but unfortunately chose one of the tax-impaired funds. We wrote about this recently, in AMLP’s Tax Bondage. Although the title reflects our own shot at search engine optimization, the blog post highlights the tax drag that has led to AMLP performing at less than half its index. This might be the worst ever result for a passive ETF. It’s a regular subject for us, and recently Forbes published a splendid analysis of the burden faced by unwitting investors in such funds (see A Tax Guide to MLP Funds). Writer Bill Baldwin did some serious work to validate what we’ve been saying, and has performed a great service to investors in tax-burdened MLP funds everywhere.

The point of the tax discussion is to remind investors in the wrong type of energy infrastructure fund that this is a great time to sell (probably realizing a tax loss that might be a  useful offset against a FANG stock), so as to switch into a tax-efficient fund (which is the only kind we run).

In summary, pervasive energy infrastructure weakness awaits evidence that FCF growth is coming, and the timing is great for a portfolio upgrade by shedding tax-inefficient funds. This is the two-pronged message to investors and prospects in the sector. As conference attendees prepared to return to homes and spouses that are mostly located somewhere colder than Florida, the limited opportunity to get tanned was probably for the best.

Will MLP Distribution Cuts Pay Off?

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It’s surprisingly difficult to find out what MLP distributions have been doing. Alerian claims that their index has been growing its payouts at a 6% average annual rate for 10 years, with growth continuing in 2016 (it’s not yet updated for 2017). However, their methodology is odd. They take the trailing growth rate of the current index constituents, which are regularly updated. This tends to bias the growth rate up, because they dump poor performers and add good ones. We examined this in a recent blog (see MLP Distributions Through the Looking Glass).

Because Alerian doesn’t publish the actual experience of its index investors, it’s necessary to look at how investment products tied to those indices have done. Not surprisingly, payouts have fallen. As the chart shows, for the JPMorgan MLP ETN (AMJ) and for the Alerian MLP Fund (AMLP), two of the largest vehicles in the sector, dividends are down approximately 30% from their highs in 2014-15. This is what MLP distributions have been actually doing – falling, not rising — in spite of what is sometimes implied. Perhaps coincidentally, the cut in payouts is similar to the drop in the sector (38%) from its August 2014 highs.

As we’ve written before, the Shale Revolution induced many MLP managers to pursue growth opportunities (see More on the Changing MLP Investor). The need for growth capital pressured financial models that historically distributed 90% of Distributable Cash Flow (DCF), when growth needs were minimal. Leverage rose, growth projects were favored over reliable payouts, and distributions were cut. Investors felt let down if not deceived.

Although the big picture is simple, at each company level there are more detailed reasons why growth plans that were not expected to threaten payouts nonetheless led to cuts. Plains All American (PAGP) saw its Supply and Logistics business drop from $900MM in EBITDA to less than $100MM over two years. Kinder Morgan (KMI) was hurt by the cyclicality of its Enhanced Oil Recovery business. But broadly speaking, the dividend cuts were a redirection of cashflows into new projects, rather than reflective of poor operating results.

Over the next couple of years we’ll see if that redirection of cash pays off. The Miller-Modigliani model of corporate finance holds that investors should be indifferent to a company’s capital structure, and should not value dividends (since anybody can create a 5% dividend by selling 5% of her shares annually). Although financial markets don’t always operate that way, the question hanging over the industry is whether these redirected cashflows will eventually deliver their pay-off. If the foregone dividends have been wisely invested, DCF should grow.

We’ve looked at this for the components of the American Energy Independence Index. It consists of 80% corporations and only 20% MLPs. Since many MLPs have converted to C-corp status, energy infrastructure is leaving MLPs with a diminished status. It includes some Canadian companies, since they also operate U.S.-based infrastructure assets and, as we’ve noted, have been rather better run of late than their American peers (see Send in the Canadians!).

Using company data and estimates from JPMorgan, we calculate a two year compound annual growth rate of DCF for this group of businesses of 15%, from 2017 to 2019. Some of these companies were in the Alerian index but left as they became C-corps, some were never in, and some still are. A perfect match is impossible because the constituents of the Alerian MLP index have changed over the years. But that 15% growth rate will significantly support the correctness of those decisions to redirect cashflows from payouts to new opportunities. It won’t be true in every case, and to be sure many investors would have preferred it didn’t happen. But it will provide a form of vindication for managements that increased investment back into their businesses.

The sector has been priced as if the distribution cuts were fully reflective of weaker operating results, whereas in most cases they’ve been to support future growth. Investors appear to be assuming away the foregone distributions, as if the operating cashflows supporting them have disappeared, whereas many companies have been financing growth plans with this internally generated cash.  MLP investors are likely not passionate about Miller-Modigliani, but we’ll see in the months ahead whether the theory has worked.

We are invested in KMI and PAGP

Send in the Canadians!

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August 2014 was the peak in the U.S. energy sector, as long time investors know too well. The Alerian MLP Index remains down by more than a third, and larger firms are increasingly abandoning the structure to become regular corporations (“C-corps”). The Shale Revolution has tested the old model of paying out 90% or more of cashflow. It worked when growth opportunities were limited, but nowadays every MLP has identified profitable areas in which to invest. Secondary offerings, how growth is financed, have found MLP investors to be unenthusiastic about reinvesting their dividends. This has in turn depressed MLPs as they’ve issued equity to unwilling buyers in order to finance their growth plans.  “Simplification” which generally involves conversion to a C-corp with adverse tax consequences for existing MLP equity holders, allows access to a far broader set of investors. The hope is that they’ll be more willing to finance the growth opportunities presented by the Shale Revolution.

Given the resurgence in U.S. hydrocarbon production in recent years, weakness in the sector that provides transportation, processing and storage was not inevitable. The famous “toll-model” of MLPs should have simply meant that more volumes meant more tolls. One might have expected the exploration and production companies to over-reach in their giddy search for more fossil fuels. There’s a good reason for the old saying, give an oilman a dollar and he’ll drill a well. We’d add, give a pipeline operator a dollar and he’ll build another pipeline. MLPs have often sought growth with irrational exuberance. Rising leverage, distribution cuts and broken promises followed. Many concluded that the MLP model was broken; in fact, the MLP model was fine but not suited to financing a growth business. Energy infrastructure used to be synonymous with MLPs, but so many have abandoned the structure that the Alerian MLP Index is no longer representative.

Canadian energy infrastructure companies have been run differently, and the chart above shows how the three largest firms (Enbridge, Pembina and TransCanada) have outperformed their U.S. peers. During the 2008 financial crisis, conservative management of Canadian banks generally helped them avoid the excesses that plagued some large U.S. ones. The same Scottish Presbyterian cultural roots appear to have similarly protected Canadian energy companies.

Canada doesn’t have MLPs, so Canadian energy infrastructure businesses are organized as conventional C-corps. Comparing the three Canadians with their U.S. U.S. C-corp peers, their leverage (Debt/EBITDA) is in line at around 4.9X. On an Enterprise Value/EBITDA (EV/EBITDA) basis, they’re slightly higher than the median U.S. C-corp at 13X versus 12X. And they’re expected to grow their dividends at around 10% this year.

The big difference is that the Canadians have achieved this without becoming over-leveraged, with the consequent cutting of dividends. Some U.S. MLPs converted to C-corps, in effect cutting payouts by merging with their C-corp GP. Others, such as Kinder Morgan three years ago, simply cut. Broadly speaking, Canadian management teams have behaved more conservatively and been more mindful of commitments made to their dividend-seeking investor base. With few exceptions, American managements have not.

The Shale Revolution has been a U.S. phenomenon; Canada has very little such activity, with its oil production centered on tar sands, a more expensive process that requires the same type of long-term capital commitments as the conventional oil business. But the North American pipeline network is highly integrated. Enbridge (ENB) demonstrated this by acquiring Spectra Energy two years ago, greatly increasing their U.S. network in the northeast. TransCanada (TRP) purchased Columbia Pipeline Group in an all cash deal, gaining a leading natural gas position in the rapidly growing Marcellus and Utica that links all the way down to the Gulf Coast. Not to be left out, Pembina (PBA) combined with Veresen, expanding their Bakken presence and gaining exposure to the U.S Rockies. So Canadian firms have been expanding their U.S. operations, but their greater financial discipline has enabled them to avoid imprudent growth. PBA in their most recent investor presentation on Slide 18 lists “Financial Guard Rails” which includes 80% of EBITDA from fee-based sources and maintaining an investment grade rating.

American management teams have been more risk-oriented in reaching for growth, and the results have largely fallen short of expectations. Last April, undaunted by not having $1.5B, NuStar Energy (NS) spent $1.5BN to acquire Navigator Energy’s Permian oil infrastructure network. In their 4Q17 earnings call management commented that Navigator’s EBITDA contribution was $14.5M for the quarter, yet they expect to spend another $240M building it out in 2018.  Hence the continued need for additional capital. Recently NuStar duly merged their General Partner with their MLP (simplified), which led to a distribution “reset” (cut). They sought growth over stability, and so far have achieved neither.

NS was simply one of the most recent in an ignominious history of American energy businesses that have failed to achieve what they promised. Kinder Morgan led the way in 2014, when they chose their growth plans over continuing stable distributions. Williams Companies (WMB), Plains All American (PAGP), Targa Resources (TRGP), Semgroup (SEMG) and Oneok (OKE) have all diverted cash from investors to new projects. Macquarie Infrastructure (MIC) remains the most brazen. As we noted in a recent blog post (Canadians Reward Their Energy Investors), when the company recently slashed its dividend after raising it the prior quarter, the CEO said it was necessary in order to pursue their growth agenda.

Warren Buffett was on CNBC the other morning, and when Becky Quick asked him if Berkshire would consider paying a dividend, he replied, “…dividends have the implied promise that you keep paying them forever and not decrease them..” U.S. energy infrastructure managers clearly feel differently.

Canadian energy infrastructure businesses have outperformed their U.S. peers because they’ve remained true to their original investors. They haven’t pursued imprudent growth, and they haven’t forgotten why their investors own their stock. MLP investors can no longer rely on a security’s yield because it’s become standard market practice to cut it either directly, or indirectly through a simplification. The older, wealthy Americans who were the quintessential long term MLP investor are gradually being replaced by institutions, because C-corps are an increasing portion of the energy infrastructure sector. Canadian firms are among the best managed, and so far they’ve been more adept at exploiting the Shale Revolution than U.S. firms.

This is why we created the American Energy Independence Index. By including Canadian companies and limiting MLPs to 20%, it’s more representative of U.S. energy infrastructure as well as conducive to being tracked by tax-efficient funds. The good news is that if American firms start being run like the Canadian ones, they could see a valuation uplift. The broad energy sector is out of favor, and given the positive tailwinds of growing North American oil and gas output there’s certainly plenty of upside. But the original MLP investors are unlikely to participate – they’ve been too badly let down. This remains the simplest and most plausible explanation for continued weakness. February was the worst month since January 2016, following which a strong rally ensued. Valuations, fundamentals and sentiment are sufficient to cause a repeat.

We are invested in ENB, KMI, NSH, OKE, PAGP, PBA,  SEMG, TRP and WMB

Canadians Reward Their Energy Investors

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On Thursday Energy Transfer Partners (ETP) released earnings that beat expectations on just about every measure. Midstream infrastructure businesses generally don’t report results too far from consensus – surprises usually come in other ways (more on this below). ETP’s $1.94BN of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) was more than 10% ahead of Street estimates. NGL/Products, Midstream, Natural Gas and Crude Oil segments all delivered impressive results.

ETP’s yield has remained frustratingly high for investors and management. At 12%, it reflects substantial investor skepticism about the prospects of its continuation. CEO Kelcy Warren might have felt that Thursday’s results would cause a sharp revaluation higher, whereas ETP managed a muted 4% gain. Its yield remains stubbornly high.

Earlier in the week Warren had testified in Delaware at a civil class action suit against ETP’s General Partner, Energy Transfer Equity (ETE). The plaintiffs contend that a 2016 issuance of convertible preferred securities to 31% of unitholders (ETE senior management) represented an impermissible transfer of value away from investors. We have written about this before (see Will Energy Transfer Act With Integrity?) The offending securities were issued at a time of severe weakness in ETP and ETE stock prices due to the ultimately failed effort to merge with Williams Companies (WMB).

In short, the securities allowed management to reinvest their future dividends at the then current low price, but further protected them from future dividend cuts. A rising stock price would see them reinvesting at an historic, lower level, and if the price fell due to a dividend cut their special dividends would be partially protected.

It looked like an aggressive ploy to force WMB to cancel the deal, since the result was to dilute the value of the merger to WMB investors. But even after the deal collapsed for other reasons (a revised tax opinion that conveniently rendered it unworkable), the new securities remained.  Kelcy’s ill-advised pursuit of WMB justified issuing special securities with the stock price at its low, and he wanted to keep them.

Investors sued ETE, quite rightly claiming self-dealing by management. Judge Glasscock will soon decide the legal outcome. However, the market has already offered its opinion. Energy Transfer is a well-run business that will provide management a sweetheart deal given the chance. Strong operating results from attractive assets receive a valuation discount because of sly management. As we said once before, investing with ETE is like sitting at a high-stakes poker table with a strong hand drawn from a deck of marked cards. Energy Transfer’s securities are valued accordingly.

Last week Macquarie Infrastructure Corporation (MIC) showed why investing for the long term requires a management team that shares this vision.

In a move that stunned investors, MIC announced weak operating results, lower guidance and a dividend cut. MIC’s infrastructure businesses are not limited to energy, since they have an aviation division too. But they are included in some energy infrastructure indices as well as held by investors who focus on the sector. They just showed why market sentiment towards such businesses remains so poor.

As recently as November, MIC announced a 10% dividend hike, forecasting 2018 growth in Free Cash Flow (FCF) of 10-15%. Just three months later, they cut the dividend by 31% and lowered their FCF growth forecast. It’s true there had been a change in CEO in the interim, but investors had little reason to expect this type of outcome.

The subsequent conference call showcased why so many investors have lost faith in infrastructure businesses. When asked to justify the dividend cut so soon after raising it, CEO Christopher Frost commented, “Could we have taken a different path?…Yes…But maintaining our dividend policy would likely have meant…forgoing our growth agenda” (emphasis added).

This is exactly what has alienated investors and caused new buyers to pause. MIC invited a set of equity holders that valued growing dividends. They then chose to repurpose those cashflows to invest in new projects, even though they haven’t recently demonstrated much ability to estimate returns on investment. So what type of investor should hold MIC? A fairly fleet-footed one.

A management team that doesn’t have a consistent long term outlook will draw investors who don’t care about the long term view. MIC was understandably down 38% on the day. It’s unclear what anybody should expect from the company.

Too many American energy infrastructure businesses have let investors down. Often they’ve chosen growth over what their existing financiers want, and sometimes they’ve ignored their fiduciary obligation, shredding expectations and losing support. Valuations are attractive in part because of management teams that continue to alienate investors.

It doesn’t have to be so. Canada’s Pembina Pipeline Corporation (PBA) also announced good results last week. They have no history of issuing special management-only securities. They generally do what they tell you. They describe their financial model as based on “guardrails” with metrics oriented towards 8-10% FCF growth while maintaining their investment grade credit rating. On their conference call they said acquisitions were low on their list of priorities, behind operating existing assets more efficiently and building from scratch. Investors rejoiced, driving their dividend yield down to 5.25% as the stock rose. The Canadians seem to be getting it right.

We are invested in ETE and PBA

Discussing the Shale Revolution with Enlink Midstream

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We thought it would be interesting to learn how the Shale Revolution has changed some of the midstream infrastructure businesses that support it. What have these companies learned, and how are their operations affected?

For the first in an occasional series on this topic, we chatted with Adrianne Griffin, Director, Investor Relations with Enlink Midstream (ENLK). Four years ago, ENLK was created when Devon Energy (DVN) combined its midstream infrastructure assets with those of Crosstex. Because DVN controls ENLK through its ownership of the General Partner (GP) Enlink Midstream, LLC (ENLC), the two businesses remain tightly linked. DVN can claim to own some of the original assets that led to the Shale Revolution; George Mitchell was an early pioneer of horizontal fracturing (“fracking”), and in 2001 DVN acquired its eponymous company which had unlocked natural gas reserves in the Barnett Shale, in north Texas. Without the Shale Revolution, it’s unlikely ENLK would have been created.

Like all energy infrastructure businesses, ENLK’s relies heavily on the activities of its oil and gas producing companies. Anticipating shifts in production is crucial to ensuring that pipeline and other capacity is available as needed. As the Shale Revolution has gained importance, companies like ENLK aim to align their capacity with customer demand. An under-utilized pipeline represents an inefficient use of assets, but no producer wants to find that output can’t be cheaply processed and transported. The alternatives are to move product by train or truck, both of which are more flexible but substantially more expensive and less safe.

Although the improvements in technology have largely been at the producer level, the resulting increased production certainly impacts the need for infrastructure. Ms Griffin discussed how multi-well pad drilling had dramatically boosted efficiency, since today it’s not uncommon to see a row of four pads with four rigs drill two dozen individual wells. She contrasted this with past practice of drillers poring over maps and selecting single well locations with a marked dot. Today, it’s increasingly common to see software engineers remotely guiding multiple drilling rigs from a central control station (see Drillers turn to big data in the hunt for more, cheaper oil).

Although the Barnett Shale was where the Shale Revolution began,  it was long eclipsed by prolific gas output from the Marcellus in the northeast and oil production in the Permian Basin in west Texas. Oklahoma’s “Scoop and Stack” is another high-producing region, and ENLK is well positioned to benefit from increasing production there. Techniques originally developed in Mitchell Energy’s original acreage have been successfully transferred from north Texas to Oklahoma. Although ENLK is slowly diversifying its customer basis, it’s no surprise that DVN is 50% of their business in that region.

Pressure is the name of the game. Ms. Griffin explained why “Keep the pressure low” is a constant refrain. If the pressure at which existing oil and gas are moved through the pipeline network is too high, it makes it harder for new production to enter the system. A key element of managing flow is to find the right balance between optimal management of the pipeline network that still accommodates additional supply coming on. Shale wells are characterized by high initial production rates that decline quickly. When you combine this with multi-well pad drilling, it can lead to producers quickly adding new supply that soon tapers off. In order to manage overall pipeline pressure, drillers often leave some wells as Drilled Uncompleted (“DUCs”), or choke back initial output, in order to deliver less variable flow to their midstream infrastructure provider. Drillers and their infrastructure providers are in constant contact.

On the processing side, ENLK have been investing in new, cryogenic processing plants, because the gas stream they’re asked to process is a lot “richer”. This means it contains Natural Gas Liquids such as ethane and propane, which must first be removed and sold separately before the methane can be supplied to customers as natural gas.

In an interesting twist, DVN recently announced plans to divest its acreage in the Barnett to focus on Oklahoma and West Texas.   However, technology has improved tremendously since George Mitchell’s day, and it’s allowing the re-exploitation (‘re-frack”) of wells that were previously regarded as having little remaining commercial value for new potential owners.

Since ENLK is an MLP with a GP, no discussion would be complete without asking about the financing model. Over the past couple of years most large MLPs have combined their GP and MLP. Euphemistically called “simplification”, it’s generally resulted in lower distributions and unwelcome tax consequences for investors. Although management teams typically blame the difficulty of raising equity capital with the GP/MLP structure, the problems are invariably self-inflicted as overly ambitious growth plans stretch distribution coverage and leverage covenants. NuStar’s recent combination with its GP, NuStar GP Holdings, is an example.

While ENLK has certainly benefited from a strong corporate sponsor in DVN, they’ve also maintained leverage at 3.5-4X Debt:EBITDA, and have managed their growth so as to retain an investment grade debt rating. More than three years since the peak in the energy infrastructure sector, it’s a prudent approach that is paying off.

We are invested in ENLC

Shale Leads Growth in Proved Reserves

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On Thursday the U.S. Energy Information Administration (EIA) released updated figures on proved reserves as of 2016. In order to count as proved, companies must be reasonably certain that the reserves are recoverable under existing operating and economic conditions. Improvements in technology have increased the amount of recoverable reserves from some shale formations.

The dramatic increase in Permian reserves is driving increased production. As we noted (see Rising Oil Output Is Different This Time), Permian output is set to reach 3 Million Barrels per Day (MMB/D) in March. It’s increasingly looking as if pipeline demand is approaching capacity. JPMorgan recently said they expect pipeline bottlenecks to develop in 2H18 and into 2019, before additional capacity currently under construction is added. But they expect that by 2020 tightness will occur again. Permian production is expected to reach 3.5 MMB/D by the end of this year, and continue rising to 4.1 MMB/D through 2019 and 4.9MMB/D by 2020.

New takeaway capacity will be required by then. In recent years, midstream infrastructure businesses have rarely missed an expansion opportunity even if it led to stretched balance sheets. NuStar (NS) was the most recent firm to acknowledge such over-reach. The collapse of their GP/MLP structure and distribution cut announced ten days ago were caused in part by the failure of their early 2017 Navigator acquisition to ramp up cashflows quickly enough. The industry’s history of providing new capacity too readily has diverted cashflows from distributions to growth and debt repayment, frustrating traditional investors. They’ll be hoping that recent financial discipline sweeping across energy producers similarly afflicts pipeline operators, resulting in higher returns on future projects.

Overall U.S. proved reserves of crude oil and lease condensate were virtually unchanged in 2016 versus 2015 at 35.2 Billion Barrels. Gains in the Lower 48 states were offset by declines in Alaska and offshore. Proved reserves of natural gas rose 5% to 324 Trillion Cubic Feet, as total additions were 150% of production. The U.S. continues to enjoy a substantial cost advantage in natural gas production, with exports of Liquified Natural Gas (LNG) set to reach 10 Billion Cubic Feet per Day (BCF/D) by late 2019, 3% of global consumption.

Commodity prices affect proved reserves as they have to be commercially recoverable. The 2016 oil and gas prices used for these calculations were 15% and 6% lower than in 2015. When the 2017 figures are published they’ll be based on oil and gas prices 20-21% higher. U.S. reserves are likely to keep growing.

The American Energy Independence Index (AEITR) finished the week +2.7%.

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Rising Oil Output Is Different This Time

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Although we’re used to reading about growth in U.S. shale production, recent figures from the Energy Information Administration are still striking. Crude oil output from the Permian in west Texas is set to reach 3 Million Barrels per Day (MMB/D) in March, up by more than 70K from February. Output is growing at an increasing rate. Natural gas output is also growing – Appalachia (how the EIA refers to the Marcellus Shale in Pennsylvania, Ohio and West Virginia) is expected to produce around 27 Billion Cubic feet per Day (BCF/D) in March. The Permian represents close to a third of all U.S. crude output, and the Marcellus just over a third of natural gas.

In December, the EIA forecast Permian growth of 515K in daily output over 18 months from June 2017 to the end of this year, so the March 2018 increase is almost three months’ worth. The International Energy Agency is similarly optimistic, predicting that the U.S. will be the world’s largest oil producer by 2019. This seems like good news if you’re American and especially if you’re employed or invested in the energy sector. But the cloud on the horizon is whether this presages a repeat of the 2014-16 oil price collapse that was caused by surprisingly fast U.S. output. The WSJ noted that U.S. crude output looks set to outpace global demand in 2018, rekindling unpleasant memories. One observer tweeted “US shale firms remove pistol, aim at own foot, and fire.” However, crude prices barely dipped on the news.

U.S. oil and gas producers promise greater financial discipline following vocal investor feedback. Achieving an acceptable return on capital is now more fashionable than growing production. Chevron, Anadarko and ConocoPhilips have all recently announced dividend hikes, thoughtfully providing investors with a little Valentine’s Day love.

The bullish case for energy infrastructure rests on sustainable production growth, so although pipeline owners don’t drill for crude oil the financial health of their customers is important. Although U.S. output growth may exceed net new demand, existing oil fields experience aggregate global depletion of 3-4MMB/D, so new supply needs to cover this as well. In spite of the Shale Revolution, there’s still a need for other new sources of supply. If U.S. producers are sincere about their financial discipline, this should lead to more sustainable growth in output and good business for energy infrastructure.

Why Risk Parity Could Boost Energy Stocks

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Risk Parity is a portfolio construction technique that seeks to allocate capital so as to maintain similar levels of risk from each asset. Some commentators are blaming it for the recent market turmoil, since superficially its practitioners are expected to reduce risk when it rises. That can often mean selling stocks. AQR is among the asset managers who employ this approach. In 2010 they published a paper explaining the theory, noting that traditional portfolios typically derive a larger proportion of their risk from equities than is implied by simply looking at percentage allocations.

A 60:40 stocks/bonds portfolio will incur more than 60% of its risk from stocks, because they move more than bonds. Risk Parity seeks to compensate for this, and the paper showed improved returns over a passive 60:40 approach. The paper goes on to describe a portfolio with less equity exposure than a traditional 60:40 portfolio and correspondingly less risk. Because it has a higher Sharpe Ratio (i.e. better risk/return) but lower return, leverage is then employed to raise the risk to the same as 60:40, at which point the return should be higher.

Since allocations under a Risk Parity regime target a given level of risk, changes in risk estimates will lead to a shift in allocations, and may also require changes to leverage. One popular measure of risk is volatility. For simplicity, we’ve defined it as the average percentage daily move over the prior ten days. Although Risk Parity is typically applied to asset classes, the concept can also be applied to sectors within an asset class. A strategy of achieving Risk Parity among asset classes can also be designed to achieve Risk Parity across sectors within an asset class.

In response to criticism that funds employing Risk Parity are behind the recent sharp moves, some managers of such funds have responded that such shifts are slow – their models are designed to recalibrate over longer periods than just a few days. It’s impossible to know the extent to which the critics are right — on Friday JPMorgan estimated that most of the “severe” unwind was over. However, we’ve noticed another shift, which is that risk in the energy sector is falling relative to the S&P500. This is partly due to correlations increasing, as they do during market dislocations. Sector differentiation becomes less important than overall market exposure, and sectors move up and down together. For example, the S&P Low Volatility Index is down 6.5% for the month, almost as much as the S&P500 itself (down 7.2%), even though Low Vol should be, well, less volatile.

Nonetheless, Risk Parity strategies that are deployed at the sector level could eventually increase energy exposure at the expense of other sectors whose relative volatility against the S&P500 has increased.

It can seem an arcane topic. But put simply, in a time of heightened volatility, the Energy sector is gyrating with the rest of the market whereas it was previously moving sometimes twice as much. The first chart compares XLE with SPY, where although average daily moves have increased in both cases, SPY moves have jumped by 150% while XLE moves have “only” doubled.

Many reliable trends have abruptly shifted, including persistent low volatility. The spectacular collapse of the Credit Suisse note (XIV) following the spike in volatility was extraordinary. Why would people hold a product that seems destined to eventually blow up?

The difference in volatility is more dramatic when comparing Energy Infrastructure (defined here by the American Energy Independence Index) with the S&P500. Their average daily moves are roughly the same. Until recently, energy infrastructure (including MLPs) was moving twice as much as the broader market. Domestic, midstream assets that support U.S. energy independence have experienced a comparatively modest increase in volatility compared to the overall market. Daily moves in the S&P500 and energy infrastructure are converging. At a time of increased uncertainty, if investors begin to value the more reliable cashflows these companies generate, further buying of the sector will follow.

The American Energy Independence Index (AEITR) finished the week -4.2%, outperforming the S&P500 which was -5.2%.

The Positives Behind Exxon Mobil’s Earnings

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The sharp drop in equities since Friday is notable for missing any obvious catalyst. Interest rates have been headed higher, but they’re far too low to offer value and the Equity Risk Premium continues to strongly favor stocks over bonds. A sharp move higher in interest rates could shift relative valuations away from bonds, but we’d need to see rates 1-2% above where they are today.

Earnings have generally been good, but Exxon Mobil (XOM) disappointed with their report on Friday morning and duly dropped 10% over the following two trading sessions. They missed expectations across each segment. They have failed to make money in U.S. oil and gas production for over two years, and their refining margins were also squeezed.

However, XOM’s travails shouldn’t tarnish the outlook for energy infrastructure. First, they announced plans to invest $50BN in the U.S. over the next five years. CEO Darren Woods singled out the Permian Basin in West Texas and New Mexico as an important target for some of this capital investment. This is exactly what energy infrastructure investors should be excited about. It’s evidence that the world’s biggest energy companies recognize the value in the Shale Revolution. Unconventional “tight” oil and gas formations offer rapid payback for a small initial investment. Capital invested is often returned within two years, allowing price risk to be hedged in the futures market. In Why Shale Upends Conventional Thinking , we noted last year that XOM’s CEO expected a third of their capex to be devoted to such opportunities. In response to a question on their recent earnings call, VP Jeff Woodbury replied, “…While we continue to invest across all segments, this increase compared to 2017 is primarily driven by higher investment in short-cycle Upstream opportunities, notably U.S. unconventional activity and conventional work programs, both of which yield attractive returns at $40 per barrel.” Woodbury continued, “As I indicated before when we were talking about the five-year projection of $50 billion, that is a very attractive investment. We’ve got – at a low price forecast we’ve got returns in excess of 10% with a $40 per barrel…”

Other multinational energy companies reported good earnings, including Royal Dutch Shell (RDS) and BP.

In addition to positive fundamental developments such as XOM’s future investments focused in the U.S., energy infrastructure was completely bypassed by last year’s strong equity rally. Few investors in this sector can be guilty of irrational exuberance, and there’s unlikely to be many panic sellers. We continue to see investors allocating new money, including yesterday in spite of the sharp drop in the market. This reflects the value that investors increasingly see in the sector. Energy infrastructure companies are valued at a 9% Free Cash Flow yield based on 2018 earnings, and 10% based on 2019.

By contrast, the S&P 500 Energy Corporate Bond Index yields only 3.8%. The truly overvalued sector is the bond market, especially long term government and high grade bonds whose yields remain too low to provide a reasonable return and show overvaluation compared with stocks (see Down’s A Long Way for Bonds). Fixed income investors should consider switching into energy infrastructure equities.

Down’s A Long Way for Bonds

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In my 2013 book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors, I forecast that interest rates would stay lower for longer than many people thought. The 2008 Financial Crisis was caused in part by excessive levels of debt. Interest rates below inflation are a time-tested way to gradually lessen the burden of a country’s unmanageable obligations. The book’s forecast was right, and more importantly the low rate strategy has succeeded. Household debt service costs have fallen as a proportion of income. U.S. GDP is growing solidly at 2.5% and possibly faster, and at 4.1% the Unemployment rate has fallen to levels that were previously associated with rising inflation. We are enjoying synchronized global growth. In short, regarding Low Rates: Job Done.

The Federal Open Market Committee (FOMC) has been unwinding its policy of extreme accommodation at a measured pace. Short term interest rates have been lifted from 0% to 1.4%. Bond yields have also been rising, with the Federal Reserve having announced last year the end of their bond buying program. Their balance sheet is close to $4.5TN, and although they’ll continue to reinvest interest income it will eventually start shrinking as their holdings mature.

Lastly, the 2017 Tax Cuts and Jobs Act was stimulative. Falling household debt service, synchronized global growth, no more Fed buying of bonds and tax stimulus are not likely to be supportive for bond prices.

It’s true that in recent years many forecasters have mistakenly expected rates to rise faster than they have. Although the FOMC is not known for frivolity, even they must have chuckled in embarrassment at their own forecasting errors. For several years now, the FOMC has issued forecasts for the Fed Funds rate (i.e. the interest rate they control directly) only to consistently undershoot. They correctly value achieving the right policy rate more than saving their blushes as forecasters.

The challenge for bond investors, as they contemplate the declining value of their holdings, is to identify their fair value. Using ten year treasury yields as a benchmark, what is its neutral level?

The news is not good. As we noted recently (see Rising Rates and MLPs: Not What You Think), the real return (i.e. the return above inflation) on ten year treasuries going back to 1927 is 1.9%. This means that today’s investors should require at least 4% (approximately, inflation plus the historic real return). A 4% yield would deliver the average real return assuming inflation averages 2% over the next decade. Although yields are rising, the current 2.8% ten year yield is inadequate on this measure.

Synchronized global growth and fiscal stimulus are both heading in the wrong direction for a bond investor. Although the FOMC is forecasting 2.5% U.S. GDP growth this year and 2.1% next, they maintain that the long run trend is only 1.8%. This is why they’re projecting higher short term rates over the next couple of years, as well as Personal Consumption Expenditures inflation (their preferred measure) creeping up from 1.5% last year to 2% next year. In a sign that a tightening labor market is stoking wage inflation, Friday’s Employment report included a 2.9% annual increase in hourly earnings, the biggest jump since 2009.

A few weeks ago we revisited the Equity Risk Premium (ERP), which shows that stocks are cheap, relative to bonds. The corollary is that bonds are expensive relative to stocks. Yields need to rise by around 2% to return the ERP back to its 50+ year average. Historical comparisons with real returns and relative valuation to equities both argue that today’s bond market is a poor investment. Although this has been the case for several years, now the fiscal and economic stars are aligned against fixed income. It means that, if yields move up through 3%, taking the prices of many other bond sectors lower, investors considering where valuation support might lie will find little of substance in their favor.

We’re not forecasting that yields will move sharply higher — but we are noting there’s nothing fundamentally attractive about today’s levels. Bear in mind also that few FOMC members can be regarded as inflation “hawks” (does anybody even remember the term?). They’ve been dovish, correctly, for years. If inflation does surprise to the upside, bond investors may need some visible reassurance from new FOMC Chair Jerome Powell that he possesses “inflation-fighting credentials”. Earning such credibility would require raising short term rates even higher.

In September, ten year yields were close to 2% before beginning their current ascent. The last time we saw a 2% increase in yields (i.e. what it would take to return to 4%, approaching long term fair value) was in 1999, when technology stocks were leading us into the dot.com boom and subsequent bust. A generation of market participants has not experienced a real fixed income bear market. As a retired bond trader friend of mine says, when you add all these factors up, for bond prices “Down’s a Long Way”.

Unlike fixed income, energy infrastructure does offer solid valuation support. Moreover, the correlation with bond yields is historically low and likely to remain that way. Few MLP investors expect stable, boring returns anymore and rising GDP growth is good for energy demand. Selling bonds that are substantially above fair value and switching into undervalued energy infrastructure aligns with the macro forces currently at work.

The American Energy Independence Index (AEITR) finished the week -6.5%. Since the November 29th low in the sector, the AEITR has rebounded 7.6%.

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