Tax reform removed the uncertainty surrounding treatment of MLPs, in that both House and Senate plans provide some additional benefit. Although the final bill will require negotiations to reconcile the different Senate and House versions, we’ve updated the table below to reflect a 22% corporate tax rate and the Senate treatment of pass-through income for MLP investors, which is less attractive than the House. Investors in both C-corps and MLPs will be better off, and if the House’s pass-through treatment prevails MLP investors will benefit further.

The 2017 Wells Fargo Pipeline and Utility Symposium held last week included the slide below. Energy infrastructure investors need little reminder – 2017 is turning out to be a forgettable year, which has reduced valuations to the levels shown in the chart. Tax loss selling continues, since most investors have substantial investment gains and unloading some energy losers mitigates the tax bill. There’s little other justification for such moves.

People often associate breakthroughs in energy research with electric vehicles (EVs) and use of renewables to provide power. But traditional energy businesses are also the subject of considerable research and development. NET Power, based in Houston, TX, has built a pilot power plant that uses natural gas but captures the resulting CO2. They claim to have built a zero-emission natural gas power plant. Investors have provided $150MM to develop the business. It’s obviously early, but if the technology turns out to be successful on a large scale, given the abundance of natural gas in the U.S., it could be a significant solution to fossil-fuel based carbon emissions. It could even provide a legitimate clean energy alternative to windmills and solar panels. It would represent yet another dimension to the benefits to America of the Shale Revolution. New technology is often exciting, and interesting energy research isn’t limited to wind and solar.

The “Duck Curve” represents the demand for electricity during a typical day. The version from California’s Independent System Operator (ISO) highlights that peak electricity demand occurs at breakfast time when people are getting ready for work or school, and at dinner time when they return home. Although solar-generated electricity is growing, it’s worth noting that demand is highest when the sun is low in the sky or it’s dark. Therefore, traditional power plants such as natural gas are critical to providing power when it’s most needed. A speaker at a recent conference organized by R.W. Baird noted the potential problem this presents for the green credentials of EV owners, in that the obvious time to charge them is in the evening when renewables are less likely to be the source of electricity.

Regular readers will not expect us to be bullish on Bitcoin. Its recent take-off has been spectacular to watch, rather like a rocket that will inevitably crash even while its ascent is riveting. We’re reaching the stage where comparative valuations are startling: on Wednesday aggregate crypto-currency valuation exceeded the market capitalization of JPMorgan for example. CEO Jamie Dimon has called Bitcoin a fraud. You could own all the bitcoins that exist, or approximately half the publicly held energy infrastructure in the U.S. The correct choice isn’t obvious to everyone. The CME and CBOE’s proposed Bitcoin futures contracts must be the strongest evidence yet that parts of the U.S. finance industry have completely lost the plot, oblivious to their ostensible role of helping savers fund retirement in favor of creating gambling products.

What receives less attention than Bitcoin’s price is the energy consumed to “mine” new units. The computing power required to solve the increasingly complex algorithms that allow cryptocurrency units to be manufactured now consumes 29 Terrawatt Hours of electricity annually. This is more than the consumption of 159 countries. One analyst estimates that this costs $1.5BN, based on using cheap electricity in places such as China. Using recent growth rates, by next Summer crypto-currency production will consume the equivalent of America’s electricity output, and by 2020 the entire world’s. Somewhere, something will give. We’ll be spectators.

 

Investors in Master Limited Partnerships (MLPs) have more limited rights than most equity investors in corporations. They’re called Limited Partners (LPs) for a reason. There’s often a General Partner (GP) who runs the business on behalf of the LPs. GPs have preferential economics, governance and information rights, and we concluded many years ago that the GP/MLP relationship looks a lot like the one between a hedge fund manager and his hedge fund (see MLPs and Hedge Funds Are More Alike Than You Think). GPs earn Incentive Distribution Rights (IDRs) rather than the ubiquitous “2 & 20” that has financed so many hedge fund and private equity fortunes. But the result is similar, since IDRs pay the GP more as the profits of the MLP grow. Most of the big MLPs have simplified their structure in recent years. IDRs have come to be viewed as an unnecessary drag on LP returns, and it’s turned out that MLP investors aren’t a great source of capital (see Why the Shale Revolution Hasn’t Yet Helped MLPs). Simplification usually results in a collapsing of the GP/MLP dual entity into a single one. In such cases the result is often a corporation with no IDRs. The objective is to gain access to a far wider investor base in order to fund growth. Kinder Morgan began this trend in 2014 (see What Kinder Morgan Tells Us About MLPs). Energy Transfer Partners (ETP) is the largest of the remaining MLPs that retains the old structure, with Energy Transfer Equity (ETE) as its GP. CEO Kelcy Warren understands better than most how lucrative the GP/MLP structure is, since it’s created the bulk of his personal wealth which is in invested in ETE. The market price of ETP reflects some skepticism that the current arrangement will persist, as reflected in ETP’s 13% yield. Consistent with Kelcy’s swaggering posture on such issues, ETP recently raised its payout so as to convey just how confident they are in the safety of the distribution. A merger of the two entities with ETE as the surviving entity would result in ETP LPs receiving ETE units which yield “only” 7%. ETP’s high yield presumably reflects the view of many that such a transaction is possible. And yet, we calculate that ETE’s 2018 Distributable Cash Flow will jump from $1BN to over $1.8BN, due to the expiry of previously granted IDR waivers and contribution from two major projects being moved into production. This could support a substantial jump in ETE’s cash available for payouts, so ETP investors have less to fear in a combination of the two. One analyst recently suggested that ETP’s owners could band together and fire ETE as the GP, thereby unlocking substantial value for themselves at the expense of ETE. Kelcy is not a sympathetic character, and has demonstrated before that he has no fiduciary obligation to ETP, nor even to other ETE investors. The convertible preferreds that ETE issued to insiders in early 2016 are the subject of an ongoing legal challenge in Delaware court (see Is Energy Transfer Quietly Fleecing Its Investors?). This transaction showed that even investing directly alongside management in ETE carries some risk of self-dealing. In fact, investing with Kelcy is like sitting at a high-stakes poker game with a good hand drawn from a deck of marked cards. You have valuable, well-positioned assets run by a talented management team, and have to balance those against the possibility of Kelcy screwing you if he can get away with it. All these factors need to be considered in sizing your stake. ETP yields 13% because investors don’t trust the dealer. Although the notion of ETP LPs rising up in rebellion and overthrowing their monarch holds some understandable appeal, it faces some substantial challenges. Apart from the requirement that 2/3rds of the ETP LPs vote to fire the GP, a recent ETP registration statement included this language: Our partnership agreement authorizes us to issue an unlimited number of additional partnership securities and options, rights, warrants and appreciation rights relating to the partnership securities for any partnership purpose at any time and from time to time to such persons, for such consideration and on such terms and conditions as our general partner determines, all without the approval of any limited partners. ETE can always dilute a hostile group of LPs below the threshold. ETP’s attempted regicide would likely trigger a debilitating response. Such language is not uncommon across the industry. A 2016 prospectus filed by NuStar (NS) is similar: NuStar Energy’s partnership agreement authorizes NuStar Energy to issue an unlimited number of additional partnership securities for the consideration and on the terms and conditions established by the general partner in its sole discretion without the approval of any limited partners. In The Limited Rights of Some MLP Investors last year we listed further examples of this type of GP protection. Relatively weak governance rights are by no means unique to that portion of the $300BN publicly traded MLP sector that retains the GP/MLP structure. Around $3TN of capital invested in hedge funds has few rights and certainly worse liquidity. At least you can sell your MLP units if you’re unhappy. Hedge funds often respond to adversity by further limiting withdrawals. Private equity offers even less liquidity than hedge funds. Investor attempts to fire such managers are rare because they’re futile (see The Hedge Fund Mirage, Chapter 7: The Hidden Costs of Being Partners). Alphabet (GOOG) has long had three share classes, with super-voting powers attached to founders’ shares that have the practical result of ensuring minority control even if a substantial majority of aggregate shares are voted in a certain manner. Facebook, Alibaba, Volkswagen and even Berkshire Hathaway are among the large global companies that have multiple classes of equity investor. The Economist recently opined on this (see How tech giants are ruled by control freaks). The GP/MLP structure can be thought of as providing a preferred return to the LPs with the GP class sitting below them in the capital structure from an economic perspective. This is because the GP’s IDR take is linked to distributions paid to LPs, and starts out at 2%. So if distributions to LPs are cut, that can disproportionately lower the GP’s IDR take as they fall back down to the lower % splits. Moreover, recent history includes many examples of GP’s temporarily waiving IDRs, which benefits LPs over the GP at least in the near. We prefer to own GP’s because we believe their superior governance rights translate into better long term value creation, a view widely shared by their management teams. But investors routinely commit capital to equity vehicles that afford them junior rights, from MLPs to the large public companies listed above as well as the entire hedge fund and private equity sectors. It’s an imbalance that isn’t going away. We are invested in ETE, and NuStar GP Holdings (NSH, GP of NS)

 

MLP investors must wish they’d never heard of the Shale Revolution. The consequent growth in volumes of crude oil and natural gas seemed a fairly simple thesis for owners of volume-driven infrastructure assets. Increased demand for pipeline and storage capacity, for gathering and processing networks, ought to be good for the sector. But so far, a dramatically more productive domestic energy industry has driven MLP stock prices relentlessly lower. Moreover, the divergence between the energy sector and the broader averages is a common investor complaint  – the truism that MLPs are a volume business and therefore rising volumes should be good isn’t reflected in recent returns.

Early last week the International Energy Agency (IEA) published World Energy Outlook 2017 which forecasts that the U.S. will become the world’s biggest Liquified Natural Gas (LNG) exporter by the mid-2020s, and a net oil exporter by the end of that decade. Other long term forecasts, including those from the Energy Information Administration, Exxon Mobil and Goldman Sachs are broadly consistent with the IEA. MLPs slumped anyway, perhaps oblivious to the report or maybe because of it.

The Shale Revolution, the paradigm driving America to Energy Independence, has not done much for investors. It’s pressured cashflows and balance sheets of formerly stable businesses. Few management teams seem able to pass up growth opportunities, and the consequent redirection of Distributable Cash Flow (DCF) from distributions to growth projects has alienated those wealthy Americans who accepted K-1s in exchange for steady, growing, tax-deferred income. The evidence of this is most clearly seen in the defiantly high yields of some securities. Energy Transfer Partners (ETP), with its 14% payout, reflects investor disbelief that payments will continue.

Since yield no longer convinces, consider Duke Energy Corp (DUK) which delivers electricity and natural gas to over 9 million customers across the southern and Midwest U.S. It operates a highly regulated, capital intensive business.  Kinder Morgan (KMI) transports, treats and stores natural gas (including now LNG), natural gas liquids and crude oil in a highly regulated, capital intensive business. Debt:Equity at DUK is 5.6X and KMI is 5.3X, so they’re similarly leveraged. But KMI’s multiple to its Distributable Cash Flow (DCF, or Free Cash Flow less growth capex) is 8.8X. The analogous cash flow multiple for DUK is 13.2X (Net Income plus D&A minus maintenance CapEx). DUK is 50% more expensive on a cash flow per share basis.  Furthermore, the value of the land and easements acquired for pipelines appreciates over time whereas power plants eventually depreciate to zero. In this regard, DUK’s $7B/year (11% of it’s market cap) in growth CapEx becomes much more concerning.

The Utilities sector has been strong this year, which has stretched valuations while energy, including infrastructure, has lagged. The question is why investors in DUK and other similar names don’t make what looks like a substantial valuation upgrade by switching from one highly regulated business to another. KMI long ago broke its contract with the original Kinder Morgan Partners investors. When you remove a slide titled “Promised Made, Promises Kept” (see What Kinder Morgan Tells Us About MLPs) there are consequences. Redirecting cashflow from distributions to growth projects necessitated the revision to its investor presentation and took them in search of new investors.

MLPs are a shrinking part of the energy infrastructure landscape. The Shale Revolution is leading us towards Energy Independence, increasingly through C-corps (hence our new American Energy Independence Index). But the sector moves nowadays with the Oil Services sector whose biggest names are struggling with a global slump in spending on conventional oil and gas projects, whereas in the U.S. the strength in volumes and spending continues. The close relationship between oil services and energy infrastructure is not likely to sustain over the long term given their substantially different business models (cyclical versus regulated; global versus domestic).

Recent weakness may also be due to concerns that tax reform could result in lower corporate tax rates with no improvement in rates charged on passive investment income from pass-through vehicles. This would benefit C-corps over MLPs — although details on the plan continue to change, there’s probably less certainty about the ultimate tax treatment for MLPs which could be causing potential buyers to wait for clarity. The news that Norway’s $1TN sovereign wealth fund is planning to divest its oil and gas holdings certainly didn’t help sentiment either.

Returning to the chart, it shows that as growth plans took hold through 2014-15, increasing secondary offerings (how you finance growth if you pay out all your cashflow in distributions) revealed the reluctance of traditional MLP investors to reinvest those payouts. This drove yields up and hurt sector performance. Although they got there in different ways, most big MLPs concluded that the growth capital wasn’t available and so cut payouts, redirecting cash to fund projects instead. Traditional MLP investors felt betrayed and are clearly not rushing to invest in the sector, which has created today’s value opportunity.

 

MLP investors are well aware that energy infrastructure securities move with crude oil, until that relationship inconveniently broke down during the Summer. Although we move and process far more natural gas (on an energy equivalent basis) than oil, investor sentiment causes the link. Because the economic link is weaker than sometimes implied by moves in the sector, the two can part company with little warning.

Some relationship makes sense, because pipelines and related infrastructure are typically built in anticipation of future demand. Commencing pipeline operations at 100% capacity is of course the best case, but more common is a steady ramp-up of utilization. The rate at which capacity gets used up can depend on production levels in the supplying region, and production is sensitive to price.

Before the Shale Revolution, U.S. crude oil production was heading steadily lower. Today, any forecast of U.S. output must be based in part on commodity prices. The correlation between the two is sometimes higher than it should be, but it’s no longer a commodity-insensitive business.

A recent report from the National Bureau of Economic Research (The Unconventional Oil Supply Boom: Aggregate Price Response From MicroData) seeks to measure the sensitivity of U.S. oil production to price. Among their conclusions is that unconventional drilling is up to six times more responsive to prices than conventional. This is because shale projects are “short-cycle”; the payback time is far shorter. Shale drillers can hedge enough of their expected output to ensure an adequate return, not just because upfront expenses are comparatively low but also because initial production rates are high, relative to conventional wells (see Why Shale Upends Conventional Thinking). Exxon Mobil’s CEO Darren Woods commented earlier this year that a third of their capex budget was dedicated to short-cycle opportunities. It’s because they’re less risky. Conventional projects have far longer payback periods, exposing them to the vicissitudes of prices.

The growing importance of short-cycle projects has a couple of other implications for crude oil. One is that it should reduce market volatility. The greater responsiveness to price of shale production means that supply/demand imbalances are more smoothly corrected. NBER doesn’t go as far as to classify the U.S. as the swing producer (which they define as one able to react within 30-90 days), because such adjustments still take several months. But we clearly have a more sensitive supply response function than in the past. Oil prices are becoming less volatile, as we suggested might happen (see U.S. Oil Output Continues to Grow).

NBER’s conclusions include an additional insight, which is that production from unconventional wells is less variable. Not only do you get your capital investment returned more quickly, but you have greater certainty around output. In combination, these two aspects of shale should lead to lower required returns on capital. All of this is to the enormous benefit of the U.S., since shale drilling is almost exclusively an American phenomenon.

Crude prices have been rising as OPEC’s production curbs gradually take effect. Their decisions will continue to significantly impact prices. But another consequence of shale could be gradually rising prices. NBER estimates that a rise to $80 a barrel would stimulate an additional 2 million barrels a day (MMB/D) of U.S. production within two years. Investing in conventional oil and gas projects has been falling, and it’s generally accepted that we need to produce an additional 4-5 MMB/D annually to offset depletion of existing fields as well as meet new demand. U.S. shale may be part of the solution but the figures above show that other sources will need to provide the lion’s share. Earlier this year Goldman Sachs forecast that at $75 a barrel U.S. production would exceed 20 MMB/D. Cleatly there’s enormous variations in forecasts, and NBER may be overly conservative.

Therefore, gently rising crude oil prices are the most likely outcome. This can only be good for U.S. energy infrastructure. Meanwhile, Liquified Natural Gas exports are set to increase sharply. The constructive analysis on crude oil prices doesn’t apply as readily to natural gas, because global LNG trade volumes are benefiting from several new sources of supply. But as one of the lowest cost producers, the U.S. is in good shape here as well.

 

The U.S. energy sector has undergone dramatic changes over the past five years. Hydraulic fracturing (“fracking”) and horizontal drilling have roiled global energy markets. America has shifted from planning to import Liquefied Natural Gas (LNG) to exporting it, with LNG exports expected to more than quadruple over the next three years. Cheap domestic methane has made natural gas the biggest single source of electricity in the U.S., in the process supplanting coal and unexpectedly helping reduce CO2 emissions. Increasing production of Natural Gas Liquids (NGLs) such as ethane are behind close to $200BN of investments in new petrochemical facilities. Propane exports are up five-fold in five years.

In late 2016 OPEC was forced to abandon its strategy of trying to bankrupt U.S. shale oil producers with low prices, because production fell less than needed and many OPEC countries faced gaping budget holes with little to show for it (see OPEC Blinks). Almost 40% of the world’s oil producing nations had tried and failed to kill off the Shale Revolution. American free enterprise triumphed.

The dramatic increase in hydrocarbon production represents one of the greatest examples in recent years of the power of American private sector capitalism. Technological ingenuity and constantly improving productivity allowed costs of production to keep falling. The world’s biggest capital markets provided funding to support a culture of entrepreneurialism and new business formation. Highly developed energy infrastructure networks and a skilled energy labor force were already in place, and other natural resources such as water were conveniently available. Lastly, privately owned mineral rights, a global rarity, allowed individual landowners to profit from the Shale Revolution by signing drilling leases with energy companies. In short, the Shale Revolution leveraged all that’s great about America’s form of capitalism (see America Is Great!).

The changes have been so dramatic that they’re leading us to American Energy Independence. Among the many changes are the positioning of the energy infrastructure business. For years, pipelines were synonymous with reliably stable cashflows that grew modestly and required minimal reinvestment. An entire class of investment, Master Limited Partnerships (MLPs), evolved to provide tax-advantaged exposure for those willing to handle K-1s at tax time rather than 1099s. Over $50BN was raised for deeply flawed mutual funds and ETFs that provide 1099-type MLP exposure while incurring a heavy additional tax burden (see Some MLP Investors Get Taxed Twice).

Energy infrastructure is key to American Energy Independence. Steadily increasing volumes of hydrocarbons are leading to increased investment in infrastructure. Traditional sources of crude oil, such as the Permian in West Texas, are producing more than ever even after almost a century of output. More recent discoveries such as the Marcellus Shale in Pennsylvania are producing substantial volumes of natural gas where little production existed a decade ago. Although the “toll-model” of pipelines, storage assets and processing facilities still thrives, the long-term growth opportunities in infrastructure are attracting investors willing to reinvest cashflows back into accretive projects.

As a result, energy infrastructure businesses are evolving beyond MLPs, as their need for capital has not always aligned with traditional, yield-oriented MLP investors. Simplification, in which an MLP and its General Partner merge into a single corporate entity, has broadened the investor base. MLPs are nowadays an important but shrinking portion of the opportunity set.

The secular theme of American Energy Independence reaches beyond MLPs, and this is why we’re launching the American Energy Independence Index. It’s designed to incorporate those infrastructure businesses that are critical to supporting our growing energy needs. It includes both MLPs and corporations; some large Canadian companies as well as American ones, since infrastructure is highly integrated between the U.S. and Canada. In fact, the market capitalization of the corporations in the index is $300BN, approximately the same as the Alerian MLP Index. Those investors who seek energy infrastructure exposure via MLPs are limiting themselves to a steadily shrinking subset of the relevant companies. Energy infrastructure today is about growth, and many large businesses have adopted a traditional corporate structure so as to attract global investors, rather than simply those wealthy Americans who will accept the complexity of K-1 tax reporting.

Moreover, investing in MLPs via mutual funds or ETFs usually comes with the substantial tax drag noted above (see Are You in the Wrong MLP Fund?).

The American Energy Independence Index is designed to track the companies of our energy future. The Shale Revolution is bringing the U.S. closer to energy independence. Increasing volumes of hydrocarbons need to be gathered, processed, transported and stored, all of which requires additional infrastructure.

Today the index is almost fully infrastructure supporting oil, natural gas, refined products and NGLs, because those reflect our energy mix and offer reliable cashflows. Hydrocarbons will remain the dominant source of our energy for the foreseeable future, and the index consists of energy infrastructure offering consistent economic returns over the long term. This excludes coal, since it moves by rail and ship where barriers to entry are lower, and so it is not included in the index. Although the transportation and storage of renewable energy isn’t a business today, as these technologies mature and their infrastructure begins supporting similarly stable cashflows, their place in the index will grow. The American Energy Independence Index is designed to evolve with America’s changing energy needs. It is biased towards energy infrastructure that provides reliable cashflows growing over the long term.

Since 2010 the American Energy Independence Index has reflected the performance of the broader energy infrastructure sector. It has moved with the Alerian Infrastructure Index but has performed better because it’s not limited to MLPs. It better reflects the future of financing infrastructure, which still uses the MLP vehicle but relies on it less than in the past. Almost all the ETFs and mutual funds in the sector focus too narrowly on MLPs, instead of covering the entire universe of energy infrastructure opportunities.

In a few weeks we will be making available an opportunity to invest in the index. We think it represents a superior way to participate in our energy future, as America heads towards Energy Independence.

Disclosures:

References to indexes are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. The Index’s performance does not represent the results of actual trading, but was achieved by means of retroactive application of a model designed with the benefit of hindsight. Results may not reflect the impact that material economic and market factors might have had on adviser’s decision-making if adviser were actually managing client assets.