Fund flows will always beat fundamentals. This was rarely more evident than in the performance of MLPs last year. Throughout 2018, earnings reports from pipeline companies were generally in-line, with positive guidance. Operating results contrasted with stock prices, which confounded investors and management teams as they sagged. Negative sentiment worsened late in the year, not helped by broader market weakness caused by trade friction, Fed communication mis-steps and the Federal government shutdown.

JPMorgan calculates that there is $38BN invested in open-ended MLP and energy infrastructure products, across ETFs, mutual funds and exchange traded notes. In spite of peaking in August 2014, the sector saw inflows during the three subsequent years. This reversed dramatically late last year, as retail investors liquidated holdings. November and December saw $1.9BN in net outflows, enough to depress prices regardless of news.

Looking back over several years, the period looks like a selling climax, with no similar episodes visible.

Conversations with redeeming investors revealed many unwilling sellers. Taking tax losses motivated some, while others confessed to exhaustion with poor stock returns in spite of apparently improving fundamentals. Like all money managers in the sector, we were faced with little choice but to sell on behalf of such clients.

Interestingly, MLP-dedicated funds received a disproportionate share of redemptions. This makes sense, given their flawed tax structure (see MLP Funds Made for Uncle Sam). The drag from paying corporate taxes on profits has been substantial in past years of good performance.

Hinds Howard of CBRE Clarion Securities recently noted that, “MLPs are less than half of the market cap of North American Midstream, and the number of MLPs continues to shrink.  This is ultimately a good thing for those public players that remain, who will achieve greater scale and competitive bargaining power.” Many big pipeline operators are corporations, so an MLP-only focus makes less sense because it omits many of the biggest operators.

Howard went on to add that, “…it has significant ramifications for the asset managers with funds designed specifically to invest in MLPs.” This is because such funds are faced with an unenviable choice between sticking with a shrinking portion of the overall energy infrastructure sector, or dumping most of their MLPs in order to convert to a RIC-compliant status (see The Uncertain Future of MLP-Dedicated Funds). These are additional marketing headwinds on top of last year’s weak returns.

2018 fund flows suggest that investors in MLP-only funds are beginning to realize this problem, and are acting accordingly. The biggest such funds saw $2.6BN in net outflows during 2018’s latter half, 88% of the total, although they only represent 55% of the sector’s funds. Investors redeemed from tax-burdened MLP funds at almost twice the rate of the overall sector.

Many feel the sector is due a good year, and if it is, corporate taxes will lead to correspondingly high expense ratios for MLP-focused funds.

Early signs in 2019 are encouraging. The outflows abruptly ended at year-end, and investors we talk to are turning more positive. Strong January performance has helped. From where we sit, inflows dominate and new investor interest has increased sharply. Valuations remain very attractive, with distributable cash flow yields of 11%. We expect dividend growth in the American Energy Independence Index of 7-10% this year and next. Momentum seems to be turning.

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).

A few years ago Vanguard invited me to their campus to give a presentation on my just-published book, The Hedge Fund Mirage. Vanguard’s business model is the antithesis of the hedge fund industry, and they were curious to hear from that rare breed, a hedge fund critic. The company’s frugal culture runs deep. As I joked during my presentation, the only German car in the parking lot was mine. Lunch was in the “galley” (cafeteria), where my host reached into his pocket to buy my sandwich and fruit cup. This is a company whose products are usually appropriate ways to access a desired asset class.

So it was in character for Vanguard to recently ban leveraged and inverse ETFs from their brokerage platform. Such products have long been criticized because their only plausible use is for extremely brief holding periods of a few days or less. Because of their daily rebalancing, over time compounding drives their value to zero. To visualize this, imagine if you owned a security which rebalanced its risk daily so as to maintain constant market exposure. A 10% down move followed by a 10% up move would leave you down 1%. Time and volatility work against the holder, except for those able to successfully predict the daily fluctuations and time their trades accordingly. Only those seeking profits in a hurry, or trying to temporarily hedge more risk than they’d like, find them attractive. Neither resembles a long-term investor.

Vanguard’s philosophy prevents creating leveraged or inverse ETFs of their own, but now they’ve taken a logical further step to increase the distance between their clients and long term value-destroyers. They correctly noted that such products are, “generally incompatible with a buy-and-hold strategy.”

This is a popular area, with soaring volumes in recent years. It’s another example of the excessive focus on short term market direction. Consumers of financial news want to know where the market’s going today, and media outlets duly respond. But prospectuses routinely warn that leveraged ETFs will probably decline to zero over time, which means the average holder will lose money. On this basis, one might think the SEC would find banning them easily defensible. So far, while individual commissioners have voiced concern, they haven’t moved further. Finance is not short of regulation, and a philosophy that allows consumers to decide appropriateness for themselves allows innovation, and is more right than wrong. However, it works best when the products financial companies offer to their least sophisticated, retail clients are designed with good intentions. Hedge funds and other sophisticated investors can be expected to properly understand how to use leveraged and inverse ETFs – like prescription medication, their availability should be carefully controlled.

We’ve been critics of these products for years (see Are Leveraged ETFs a Legitimate Investment? from 2014 as well as The Folly of Leveraged ETFs and recently FANG Goes Bang).

In May 2016 Credit Suisse issued a 2X Leveraged ETN linked to the Alerian index. Since then it’s down 55%, while the index is down 12% (including distributions).  Losses are only limited to two times the index over very short periods. This type of long term result is common. It’s unrelated to the index and invariably worse, which Credit Suisse, and Alerian (who allowed their index to be licensed) would have known at the outset. Either name attached to an investment should give the buyer pause. It’s why these products shouldn’t be offered to retail investors.

Energy infrastructure remains one of the most attractively valued sectors around. The American Energy Independence Index yields 6.75%, and we expect dividends to grow 6-7% this year. This is attractive enough for the long-term investor, and isn’t available as a leveraged product.

On Wednesday, January 16th at 1pm Eastern we’ll be hosting a conference call with clients. If you’re interested in joining, please contact your Catalyst wholesaler, or send an e-mail to SL@SL-Advisors.com.

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).

Blog pageviews and comments help us gauge how relevant our topics are. Writing is more enjoyable when readers engage. This blog gets reposted across many websites, including Seeking Alpha and Forbes.com. The feedback from subscribers often leads to a useful dialog and informs later choice of topics. Below are the themes that resonated in 2018.

The name Rich Kinder strikes a raw nerve with many. Kinder Morgan: Still Paying For Broken Promises revealed the depth of feeling among many investors. This is because Kinder Morgan (KMI) began the trend towards “simplification”, which came to mean distribution cuts and an adverse tax outcome. To get a sense of the betrayal felt by some, peruse the comments on the blog post on Seeking Alpha where readers can let rip in a mostly un-moderated forum. It becomes clear that cutting payouts has severely damaged appetite for the sector, something we realized through this type of feedback.

A similar post examined how Energy Transfer (ET) had lowered payouts for certain classes of investor, (see Energy Transfer: Cutting Your Payout Not Mine) and drew an even bigger response (272 comments). ET CEO Kelcy Warren is a controversial figure. Our post showed that while original Energy Transfer Equity investors had avoided distribution cuts, holders of Energy Transfer Partners, Sunoco Logistics and Regency Partners hadn’t fared so well.

Kelcy Warren inspired our most colorful graphic in August, when he said, “A monkey could make money in this business right now.” (see Running Pipelines Is Easy). ET’s stock has lost a quarter of its value since then, even though their financial performance has justified his comments.

Last year was a testing one for those convinced the Shale Revolution should generate investment profits. In Valuing MLPs Privately; Enterprise Products Partners we laid out how a private equity investor might value the biggest publicly traded MLP. It wasn’t controversial, but many readers communicated their appreciation at this type of analysis.

The problem for the sector has always been balancing high cash distributions with financing growth projects. We think current valuations focus too much on Free Cash Flow (FCF) without giving credit to Distributable Cash Flow (DCF). FCF is after growth capex, while DCF is before. We illustrated this with a short video (see Valuing Pipelines Like Real Estate).

Early in the year we wrote several blog posts highlighting the tax drag faced by most MLP-dedicated funds. Because they pay Federal corporate taxes on investment profits, 2018’s bear market didn’t expose their flawed structure the way a bull market will. We won’t repeat the argument here, but it’s laid out in MLP Funds Made for Uncle Sam.

A related topic we covered several times was the conundrum facing MLP-only funds, given that many big MLPs have converted to regular corporations. MLP-only funds can no longer claim to provide broad sector exposure, since they omit most of the biggest North American pipeline companies. But the funds themselves can’t easily broaden their holdings beyond MLPs, which creates some uncertainty for their investors. We explained why in Are MLPs Going Away? and The Alerian Problem.

We returned to the tension between using cash for growth versus distributions in Buybacks: Why Pipeline Companies Should Invest in Themselves. The industry continues to reinvest more cash in new infrastructure than is justified by stock prices. In many cases, share repurchases offer a better and more certain return than a new pipeline. Trade journals are full of breathless commentary on the need for more export facilities, more pipelines, more everything. It’s not pleasant reading for an investor, but this is the world inhabited by industry executives. More mention of IRR would be welcome. Pipeline investors are hoping that the Wells Fargo chart showing lower capex in the future will, finally, be accurate.

Fortunately, there are signs of better financial discipline. Leverage continues to drop and dividend coverage is improving, which will support a 6-8% increase in dividends on the American Energy Independence Index in 2019. As the year unfolds, we expect investors to cheer a long overdue improvement in returns.

We are invested in ET 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).

For investors who seek despondent sellers, look no further than energy infrastructure in late 2018. The Alerian MLP Index made its all-time high way back in August 2014. It currently sits 43% lower (including dividends). Barring a strong recovery in the last days of December, returns for three of the past four years are negative. Not coincidentally, MLP distributions are down for their fourth straight year. The Alerian MLP ETF (AMLP) has cut payouts by 34%, with its most recent one last month. Investors don’t want dividend cuts, they want dividend hikes – and in 2019 they will see them.

The shift of MLP Distributable Cash Flow (DCF) from distributions to funding growth projects has been well documented (see Will MLP Distribution Cuts Pay Off?). Growth capex (i.e. where that money went) dipped in 2016 but has been robust since then. Valuations continue to be more reflective of Free Cash Flow (FCF), which is after capex, whereas we think DCF (before capex) is more relevant (see Valuing Pipelines Like Real Estate). But investors are skeptical that cash formerly paid out is being well spent, and resentful of the dozens of cuts. Rising payouts should help.

Pipeline company earnings calls are full of positive reports with optimistic guidance. Business has rarely been this good. In August, Energy Transfer (ET) CEO Kelcy Warren memorably said, “A monkey could make money in this business right now.” (see Running Pipelines is Easy). Business conditions have only improved since then. In November, ET reported another strong quarter, beating Street estimates of EBITDA by 11%. Yet ET’s stock slumped, and is down 33% from its late July “business is easy” level, even though that description seems accurate.

No other metric explains sector performance as well as the path of dividends (or distributions for MLPs).

It’s rare for an industry to cut dividends when profits are growing, but that’s exactly what this sector has done. Falling dividends are so often associated with poor operating performance that investors reasonably equate the two – especially yield investors. Pipeline management teams consistently report on terrific business conditions and lament their stock’s low valuation. Part of the reason is that management teams too often invest in new projects rather than buying back stock. Buybacks with DCF yields of 14% and higher must surely be more compelling (and less risky) than all but the most attractive new investments. It’s no wonder investors question their judgement.  Williams Companies (WMB) CEO Alan Armstrong recently said, “I don’t recall a time in my years in executive management when the business has been this healthy but the equity markets so poorly reflecting that.”

While business is booming and valuations are very attractive, Alan Armstrong and others still fail to appreciate (or at least don’t acknowledge) the crushing effect dividend cuts have had on investor appetite for their stocks. No other explanation fits the facts as well. Some blamed crude oil for the 2014-16 collapse, but MLPs only modestly participated in the subsequent crude rally. Recently we read an analysis that attributed stock weakness to rising leverage, but leverage peaked in 2016 at around 5.5X Debt/EBITDA and is comfortably heading lower. We estimate that our portfolio companies’ will exit next year at 4.1X, comfortably within the range that prevailed before the 2014 MLP market peak.

For almost a decade, Williams Partners (WPZ) investors were trained to expect gently rising distributions that came with a tax deferral and a K-1. This happy arrangement was abandoned when Shale Revolution growth opportunities presented themselves. The first cut came when WPZ combined with Access Midstream (ACMP), formerly Chesapeake’s midstream business before it was spun out. WPZ adopted the lower, ACMP payout which resulted in an effective cut for legacy WPZ holders. Two years later, partly due to concerns about leverage, WPZ imposed a second outright cut. The final one came when WPZ was folded into Williams Companies (WMB), in a “simplification”. WMB’s lower payout was applied to WPZ holders, along with a tax bill on recaptured income.

Long-time WPZ investors have endured a 53% cut in their payouts, which are back to the levels of 2006. Having been taught to focus on distributions and ignore market gyrations, they must find Alan Armstrong’s upbeat comments incongruous if not insulting.

Nonetheless, Alan Armstrong is right that business is good. It’s just that he and his peers have so mistreated their investors that his enthusiasm is less infectious than he might like.

A useful perspective on valuations is to compare pipeline companies’ current EV/EBITDA premium to the energy sector versus its long term average. Even by the unloved standards of the energy sector, midstream infrastructure is historically undervalued.

The American Energy Independence Index (AEITR) includes North America’s biggest pipeline companies, and is 20% weighted to MLPs. Dividends paid by corporations have been more reliable than MLPs; 2018 dividends on the index are up 7%, following a 3% increase last year. By contrast, dividends on the Alerian MLP and Infrastructure Index, as represented by its index fund AMLP, are down 6% following a 16% drop in 2017. Since MLP payouts are a bigger portion of their available cash flow, they had farther to fall. But the limited investor base (largely U.S. individual investors) has inhibited their flexibility in managing cash.

As a result, many large MLPs have converted to corporations, so an MLP-only view of energy infrastructure (as with the Alerian MLP Index for example), fails to fully represent the sector. Moreover, MLP investors invest for income, which has made them an unreliable source of capital when their income is being cut.

In 2019 we expect AEITR dividends to grow high single digits. MLP distributions should also begin growing for the first time since 2014, although not by as much. Corporations generally offer faster, more reliable growth.

We wish all of our readers a Happy Christmas and holiday season. Enjoy the time with family, and we’ll all look forward to a rebound in 2019.

We are invested in ET and WMB. 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).

Canada’s struggles to get its crude oil to market have been a source of immense frustration if you’re an Albertan oil producer, or a huge success if you’re an anti-fossil fuels activist. Last week, Alberta’s premier Rachel Notley imposed almost a 9% cut in production in order to raise prices. Shortage of available infrastructure had opened up a price discount as wide as $50 per barrel between the bitumen-based Western Canadian Sedimentary Basin, and the WTI benchmark. Unusually, it led to Canadian producers asking the government to intervene.

The heavy, viscous crude from Canada’s oil-sands is reviled by activists because its extraction is particularly disruptive to the local environment, as well as requiring substantial energy inputs to heat it. The Obama Administration repeatedly held up the Keystone XL expansion because of its view that this type of crude should remain in the ground. Alberta has been frustrated at every turn in obtaining cost-effective transport for its output. Earlier this year, Kinder Morgan (KMI) gave up on their Trans Mountain Expansion, intended to increase pipeline capacity west to British Columbia’s Pacific coast. Navigating inter-provincial politics threatened to derail the project, and KMI managed to unload it on the Canadian Federal government not long before an adverse court ruling added further delays (see Canada’s Failing Energy Strategy).

Canada has unique challenges, revealing the weak hand their Federal government has in dealing with its sometimes unruly provinces. But pipeline construction has been hampered in the U.S. too. Energy Transfer’s (ET) Dakota Access Pipeline (DAPL) was delayed by Obama because of concerns over its proximity to land held sacred by some native American tribes (others were supportive, generally depending on the likelihood of financial gain through the use of their land). Shortly after his inauguration Trump allowed DAPL to move forward. But ET has at times run afoul of regulators during construction, drawing hundreds of violations during the construction of two natural gas pipelines. The industry needs ET to do better.

Shortages of infrastructure in west Texas have led to flaring of natural gas as well as impeding the growth of crude production. The completion of new pipelines by late 2019 should help. The Energy Information Administration expects Permian output to grow by 600 thousand barrels per day next year, to 3.9 Million Barrels per Day (MMB/D). The new pipeline takeaway capacity could enable it to reach 5 MMB/D by 2020, bringing U.S. output close to 13 MMB/D.

New England suffers from too little investment in natural gas infrastructure, with the result that during cold winter months they import liquefied natural gas from Trinidad and Tobago (see An Expensive, Greenish Strategy).

In many parts of the country (apart from Texas and Louisiana), energy infrastructure is becoming steadily harder to build. The losers clearly include consumers, such as those in the north east who have to pay more for electricity. In Canada, clearly oil producers suffer from the steep discount on their production. But less growth in infrastructure increases the value of what currently exists. Because Permian crude can’t all get to its desired destination (usually Cushing, OK or Houston for refining/export) by pipeline, the price differential has at times exceeded $15 per barrel. Regional differentials can support pipeline profits, since when they exceed pipeline tariffs it reflects high demand. Plains All American (PAGP) has been able to charge higher prices on parts of its crude oil pipeline network in Texas for just this reason.

New pipelines enjoy network effects. Connecting a new pipeline to an existing network adds value by increasing destination choices for shippers. This has always represented a hurdle for new entrants to surmount. But the increasing role of judicial challenges by environmental activists serves to further entrench existing operators. The pipeline business is one in which companies needn’t worry too much about a disruptive new upstart taking market share. As a result, today’s big energy infrastructure companies are highly likely to be dominant for many years to come. If new pipelines are harder to build, existing pipelines must be correspondingly more valuable. An unintended consequence of pipeline opposition is to develop a pipeline oligopoly.

Last week Enterprise Products Partners (EPD) gave a presentation at a Wells Fargo conference which emphasized corporate (rather than MLP) measures of performance. By referencing more familiar terms, such as Cash Flow From Operations, rather than the MLP-oriented Distributable Cash Flow, they hope to draw more generalist investors to consider valuations, even while EPD has no plans to convert from an MLP to a corporation. We think it’s a good move – we recently highlighted EPD’s value using discounted cash flows (see Valuing MLPs Privately — Enterprise Products Partners). We also compared pipelines with buildings (see Valuing Pipelines Like Real Estate). A consistent theme from management teams is the disconnect between the strong fundamentals of their businesses and weak stock prices.

Retail sentiment remains poor. Our friend John Cole Scott of Closed End Fund Advisors notes that discounts to NAV on MLP closed end funds are at 8%, more than twice the three year average and 10% wider than the best levels of last spring.

In the Britcom Fawlty Towers, the manic hotel manager Basil Fawlty (played by Monty Python’s John Cleese) is told during one crisis, “…to remember there’s always somebody worse off than yourself.” To which he replies, “Well I’d like to meet him, I could do with a laugh.” (see here at the 1:25 mark).

In that vein, pipeline investors who nowadays believe they’re in the world’s least loved sector should spare a thought for energy services, which have recently exceeded the lows of the 2008-09 financial crisis.

For energy infrastructure investors, we think rising dividends will finally put to rest the concern over serial cuts in payouts.  The American Energy Independence Index contains North America’s biggest pipeline companies, which are mostly corporations but include a few MLPs. It yields 6.25%, and we expect 7-8% dividend growth next year.

We are invested in EPD, ET, KMI and PAGP

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).