Start with Iran. In May, Trump withdrew from the Nuclear Accord over strong opposition from foreign allies and domestic policy experts. America announced it would unilaterally impose sanctions on Iran from November 1. Critics said this would be ineffective. Since then, Iranian oil exports are down 25% and likely to fall further. Any company trading with Iran risks losing access to the U.S. banking system, a penalty sufficiently onerous that buyers of Iranian oil are wasting no time sourcing alternatives. Companies from South Korea, France, Japan, Greece, Spain and Italy have all reduced or halted purchases in recent months. U.S. oil and gas exports are a new weapon.

Coincidentally, this has also created an opportunity for exports of ultra-light condensate oil from Texas to meet Asian demand, with buyers increasingly shunning Iranian condensate. U.S. oil and gas exports are playing a bigger role.

The loss of Iranian crude oil on world markets has pushed prices higher. But the Shale Revolution has moderated the U.S. economy’s sensitivity to energy prices. The negative of consumers spending more on gasoline will be mostly offset by a resurgent domestic energy sector. The New York Times published a rare Trump-positive story, noting that the Iran strategy was working.

Germany’s heavy reliance on renewables to provide electricity has been hampered by its use of coal. Since it’s not always sunny and windy, solar and wind can’t provide a complete solution. In Germany, dirty coal-burning power plants provide the reliable baseload supply every electricity grid needs. Their emissions have negated much of the benefit of renewables, so Germany wants to burn more natural gas, which is cleaner. Its lower CO2 output makes it a natural complement to renewables (see Pipeline Investors Fight Climate Change).

Consequently, Germany is planning Nord Stream 2, a controversial pipeline that will bring natural gas from Russia to Germany. Trump is correct to ask, “What good is NATO if Germany is paying Russia billions of dollars for gas and energy?” But America can do more than just criticize; Liquified Natural Gas (LNG) from the U.S. provides an alternative not susceptible to mid-winter maintenance. Russia has used this tactic before, when negotiations with Ukraine weren’t going in the desired direction. Shivering Ukrainians found they had little leverage with Gazprom, Russia natural gas company, who is not an attractive supplier. Last week Trump promoted U.S LNG to Poland, another NATO ally.

In North America, the U.S. is providing more natural gas to Mexico, which needs it to meet growing demand for electricity. There is 11 Billion Cubic feet per Day (BCF/D) of pipeline capacity, of which Mexico is only using 4.5BCF/D. Meanwhile, the Permian in west Texas is producing more natural gas than the existing takeaway infrastructure can handle. This is limiting oil production (since gas and oil often both come out of the same well) and resulting in flaring of unused gas which nobody likes. As additional pipelines connect natural gas burning power plants south of the border, they will consume more Permian output.

Canada struggles with access for its oil exports, in part due to domestic politics (see Canada’s Failing Energy Strategy). This is why Transcanada’s (TRP) planned Keystone XL Pipeline is so important to them, since it will add up to 830,000 barrels a day of transport capacity for a country chronically short of it.

Trump overturned Obama Administration impediments to Keystone XL shortly after taking office. Although they’ve since had to contend with legal challenges at the state level, TRP expects to begin preliminary work on the pipeline in Montana later this year.

Marcellus natural gas is displacing Canadian imports in the eastern U.S., which is helping our trade balance at a moment when the Administration is focused on imbalances. Construction of Keystone XL is a big help to our northern ally. Energy is a vital component of our bilateral Canadian relationship.

Three quarters of global LNG trade occurs in Asia. Following Japan’s 2011 Fukushima earthquake and tsunami, they virtually shut down their nuclear power industry, which has made them big buyers of LNG. China and India are both looking for cleaner alternatives than coal to meet growing electricity demand. Although China recently imposed a 10% tariff on U.S. LNG imports, they previously exempted U.S. crude oil. China’s reduced purchases of U.S. LNG are being offset by other Asian buyers.

In June, U.S. crude oil exports reached 2.2 Million Barrels per Day (MMB/D). China bought almost a quarter, but other destinations included India and South Korea. We even exported 0.2 MMB/D to Canada, although they remain our biggest provider of crude with 4.5 MMB/D of different grades coming back the other way.

Exports of crude oil, natural gas liquids and LNG are all set to rise sharply in the years ahead, as new infrastructure is completed.

U.S. oil and gas exports are providing additional negotiating leverage over allies and adversaries. The Shale Revolution and energy infrastructure investments are providing vital support.

On July 6, 2013, 47 residents of Lac-Megantic, Quebec died horribly when a 74-car freight train carrying crude oil exploded in a fireball. It was the deadliest freight-train accident in Canadian history. Five bodies were never recovered and were assumed to have simply vaporized. DNA samples were required to identify others. Heat from the inferno was felt over a mile away.

In spite of this tragedy, moving crude by rail (CBR) is comparatively safe. Since 2013, safety standards have been tightened throughout North America. The International Association for Energy Economics (IAEE) found the incidence of spills with CBR to be less than for pipelines. However, this is a deceptive statistic. Once you adjust for the greater volumes of crude moved by pipeline versus CBR, as well as the greater distances covered, pipelines remain substantially safer. The report concludes that, “the risk associated with shipping crude oil is noticeably larger for rail deliveries than for pipeline deliveries.”

2,500 miles west, off the coast of Vancouver, live around 75 endangered killer whales. Their connection with Lac-Megantic is not obvious. Fortunately for the Orcas, vocal advocates have successfully made their continued survival more important than avoiding another freight train tragedy. By blocking the Trans Mountain Pipeline Expansion, they have ensured that more Albertan crude oil will reach its buyers by rail, given continued inadequate pipeline capacity.

The Trans Mountain Pipeline (TMX) was put into service in 1953, and has been in continuous operation ever since. It’s another example of the long life of installed energy infrastructure, which generally appreciates in value when properly maintained even while accounting rules allow for its depreciation. Kinder Morgan (KMI), which acquired the pipeline in 2005, had been frustrated in its efforts to more than double the capacity of TMX by adding a second pipeline alongside the first. The TMX Expansion’s approval became a provincial political football. Land-locked Alberta has few choices in exporting its crude oil.

British Columbia sought to prevent a new pipeline from Alberta reaching the Port of Vancouver. Oil that passes through on its way to export markets has little value to local residents, since British Columbia doesn’t need any more oil. Environmentalists worried about a spill, and regard Albertan oil-sands crude as exceptionally hostile to the environment (it’s true that an oil sands facility is not pretty). First Nations tribes claimed their water supplies were threatened, although of 133 indigenous groups consulted, 43 were in support. And the anticipated increase in tanker traffic at the port of Vancouver, from two to ten per week, risked displacing the dwindling community of killer whales.

It was this last point that prompted the Federal Court of Appeal to overturn the government’s approval of the expansion in late August. Although the absence of a meaningful dialogue with First Nations representatives was cited, failure to consider the increased tanker traffic, “was so critical that the Governor in Council could not functionally make the kind of assessment of the project’s environmental effects and the public interest that the (environmental assessment) legislation requires,” said the ruling, written by Justice Eleanor Dawson. Canadian law provides wildlife with considerable protections.

In a deft move, KMI had by now extricated themselves from the vagaries of Canadian energy policy. For months, they had complained about the impossibility of building a pipeline linking two provinces holding opposite views on its completion. Finally, in May they unburdened themselves of the whole sorry mess and sold TMX to the Canadian Federal government for C$4.5BN, viewed by many as a pretty full price. KMI shareholders dodged a bullet.

A few weeks after agreeing the sale of TMX, KMI estimated in a filing that completion of the expansion would cost C$1-1.9BN more than originally expected and take a year longer. On August 30^th, KMI shareholders formally approved the sale, hours after the Court of Appeal ruling. TMX was by now worth considerably less than the C$4.5BN paid — the bailout by Canadian taxpayers was complete.

Prospects for the TMX Expansion are uncertain, with a delay of two years or more seemingly inevitable. The Canadian government is considering an appeal, redoing its environmental review, and crafting legislation to force it through. Canada wants to complete the pipeline. Meanwhile, Alberta grumbles about contemplating separatism, and has in the past suggested that it might halt crude oil shipments to British Columbia altogether.

Canadian crude oil will continue to reach its buyers, although more of it will move by rail. The International Energy Agency expects CBR shipments to double over the next two years due to lack of pipeline capacity. Suncor, Canada’s largest oil and gas producer, won’t expand crude oil production until it sees progress on pipeline approvals. The persistent $25-35 per barrel discount of Western Canadian Sedimentary crude to the WTI benchmark is directly linked to limited transportation choices, and must be regarded as a huge success by Alberta’s neighbors in British Columbia. Since the U.S. is both its biggest energy customer and nowadays its biggest competitor, Canada’s position is unenviable.

American readers will be relieved that such extreme dysfunction doesn’t exist in the U.S. Recall though, Boston’s annual winter imports of liquefied natural gas from Trinidad and Tobago to keep the lights on.  Pipeline opposition isn’t limited to our northern neighbor (see An Expensive, Greenish Strategy).

The investment takeaway is that opposition to new pipelines increases the value of those already installed. When shippers resort to rail to move crude oil, their bargaining position on pipeline tariffs is weak. Oil and gas companies suffer lower revenues, consumers higher prices, and railway lines benefit if demand is sustained long enough to justify their capex. But for pipeline companies, installed pipelines with decades of useful life can represent a scarce resource. If the possibility of excess pipeline capacity concerned markets during the 2014-16 energy sector collapse, we are now headed solidly in the other direction.

We are long KMI.

Before jumping at an attractive yield, investors should pause to consider its consistency.

In recent years, traditional MLP investors were victims of one of the greatest betrayals in U.S. financial history. Older, wealthy Americans were drawn to companies that paid out most of their cashflow in distributions. For years, America’s energy came from roughly the same places in the same amounts, which meant little need for pipeline operators to re-invest in the business. The Shale Revolution changed all this – new sources of oil and gas required new infrastructure (see Will MLP Distribution Cuts Pay Off?).

MLPs decided to grow, redirecting cashflows from payouts to new projects. K-1 tolerant, income seeking investors were the quintessential long term buyer sought by every CEO. All they wanted was stable income. Although for years MLPs provided this, in 2014-15 many of them seized the opportunity to be growth businesses, which redirected cash away from investors. Alignment of interests was lost. MLPs in aggregate demonstrated that Distributable Cash Flow would be paid to investors only as long as they didn’t have any better uses for it. Payouts were cut, trust was shattered. Today’s sector remains 28% below its August 2014 high, and its recovery offers something for everyone (see Growth & Income? Try Pipelines).

Stable and growing dividends remain highly valued. Although the Alerian MLP ETF (AMLP) has cut its distribution by 30% (see It’s the Distributions, Stupid!), Alerian used to post a chart with 6% average ten year distribution growth.  Index components change, and Alerian was using the historic growth of existing index members regardless of how long they’d been in the index. This introduced a survivor bias, in that MLPs cutting distributions used to be dropped while the newly IPO’d ones they added were typically growing quickly. This confused many, because it failed to match actual investor experience. It seemed that everyone but Alerian knew MLP distributions were being cut. Facing growing criticism (see MLP Distributions Through the Looking Glass), Alerian revised their chart to better match reality.

However, energy infrastructure overall has provided far more distribution stability than shown by MLPs. The American Energy Independence Index consists of the biggest pipeline companies in America, which are mostly corporations although it includes a few MLPs as well. It yields 5.5% based on 2018 dividends, a payout that is up 10% on 2017. We expect dividend growth of almost 11% next year. While income seeking investors are naturally drawn to attractive yields, the reliability of the payout is critical.

The chart shows that Alerian MLP Index dividends fell far more than for energy infrastructure as a whole. Moreover, they still have a long way to recover back to the levels of 2014. Although we think MLP distribution cuts are mostly behind us, the group’s history is one that income seeking investors shouldn’t soon forget. By contrast, American Energy Independence Index dividends dipped but quickly recouped their losses. The members of this index have demonstrated far more reliability with their payouts.

The Alerian MLP Index yields 7.3%, although it’s only accessible via structurally flawed MLP-dedicated funds that pay corporate tax (see The Tax Drag on MLP Funds). Because tax expense for such funds flows out of their NAV, in reality, the yield is lower. The energy infrastructure sector’s 5.5% yield is accessible through conventional, RIC-compliant funds with no tax drag. Corporations have managed their cashflows, including payouts, far more reliably than have MLPs. Moreover, those lower payouts have meant more retained earnings to be reinvested back into their businesses.  This is what will drive the 10% annual dividend growth we expect 2017-19, a level MLPs failed to achieve even in the boom years leading up to the 2014-15 collapse.

As the second chart shows, when payouts are cut less in the short run, they grow faster over the long run. Energy infrastructure is a growth business that offers attractive yields. Investors who favor companies with a reliable history of dividends are likely to fare better.

We are short AMLP.

Jim Carville’s admonition during Bill Clinton’s 1992 run for President was, “It’s the economy, stupid!”

In its August 2018 edition, The Utility Forecaster warns readers to approach MLPs “with caution.” Too risky for income investors is their conclusion. MLP buyers have been badly abused, and Chief Investment Strategist Robert Rapier reminds readers of the many “simplifications” that triggered unwelcome tax bills, as well as the multiple distribution cuts. Without doubt, MLP prices have followed distributions.

In one important respect though, Rapier adopts a simplistic yet incorrect explanation. “…during a long downturn in oil and gas prices, contracts expire and MLPs had to renew agreements under less favorable terms. Many MLPs found themselves doing what was once unthinkable – they had to cut distributions.”

It’s conventional wisdom that the 2014-15 oil collapse hurt pipeline company operating earnings, which caused payout cuts. But the numbers don’t support this narrative. The Kinder Morgan (KMI) chart below shows their Distributable Cash Flow (DCF) per share alongside a significantly more volatile stock. KMI’s DCF per share is little changed from 2015 to 2016, but the share price fell by half. They cut their payout twice: once when combining Kinder Morgan Partners (KMP) with KMI (“simplification”, in which KMP investors received KMI stock with a lower payout as well as a tax bill); and again later when KMI cut its dividend. KMI was learning that MLP investors want income over the promise of growth.

To fund their growth projects, KMP was paying out most of its DCF and then seeking to recoup some of it through secondary offerings.  In effect, investors were being asked to reinvest a portion of their distributions back into the company. Many holders found this unattractive, since they spend the income. So KMP’s yield rose, which made issuing equity too expensive. KMI concluded MLP investors no longer suited their purpose, and left to become a corporation. Today, KMI yields 5.1%, with a payout more than 2X covered by its $4.7BN DCF.

MLP buyers can be focused on distributions to the exclusion of anything else. Two recent examples highlight:

In late July, American Midstream Partners (AMID) slashed its distribution by 75% so as to, “…significantly reduce leverage, provide capital for strategic growth opportunities, and create long-term value.” Although these all sound like desirable objectives for a total return investor, AMID’s stock fell 43%.

Meanwhile, Hi-Crush Partners (HCLP) tripled its distribution and now yields 23%. The higher payout is unlikely to persist, but if it’s sustained for a year the company will convert to a corporation. Whether or not this is good for investors, its stock rose 28% on the day of the announcement.

MLP investors want their income.

The chart from Bank of America is even more striking. On the MLPs they cover, they show steadily growing EBITDA with improving leverage, alongside a declining Alerian MLP Index. Falling MLP distributions clearly drove index performance more than improving financials.

It’s as if MLP investors look at payouts and little else.

Probably the simplest measure of MLP payouts is to look at dividends on the Alerian MLP ETF (AMLP), which are 30% lower than in 2015.

There were nonetheless some companies whose operating performance sagged. Plains All American (PAGP/PAA) relied in part on its Supply and Logistics division to support its distribution. When arbitrage opportunities dried up in 2016-17, almost $800MM in EBITDA evaporated, leading to a second distribution cut. Today, increased Permian volumes are boosting cashflows once more. On last week’s earnings call they forecast 2019 EBITDA growth of 14-15%.

But episodes such as PAGP were the exception – operating results for the most part held up.

As memories of the 2014-15 bear market recede, we believe the conventional explanation for it will shift. MLP prices didn’t collapse because of weak operating performance. They fell because DCF was redirected to pay down debt and finance new projects, all to achieve growth (see Will MLP Distributions Pay Off?). Income seeking MLP investors don’t want their income redirected in this way. Hence, persistently weak MLP prices which have led the shift to a corporate structure for those companies wishing to access a far larger pool of buyers.

BofA Merrill is forecasting 2016-20 distribution growth for 27 of the 32 midstream infrastructure names they cover. JPMorgan forecasts 6-10% growth 2017-19. We expect our American Energy Independence Index to grow its dividends by 9% this year and 11% in 2019.

These forecasts are supported by growing pipeline demand. There are bottlenecks in moving crude oil and natural gas out of the Permian Basin in west Texas, and in getting natural gas out of the Marcellus in Pennsylvania. New pipelines to transport Canadian heavy oil from Alberta continue to face political challenges. The Shale Revolution is driving volumes higher.

With pipeline demand and dividends both growing, the sector is poised to continue its rally.

We are invested in KMI and PAGP. We are short AMLP.

Includes corrected text and a revised chart compared to an earlier version, with respect to Kinder Morgan