Clients often want to discuss the correlation between returns on midstream energy infrastructure and crude oil prices. Prior to 2014, investors learned that pipelines were like toll roads, more concerned with the volumes passing through than its value.

The 2014-16 crude oil collapse drove down the energy sector. Alerian’s index shed 58.2% over eighteen months, and the faith was lost. Conventional wisdom became that the pipeline business took a hit with lower oil. The truth was more nuanced – sector EBITDA grew throughout that period even while stock prices sagged (see REITS: Pipeline Dividends Got You Beat). Financing growth projects caused distribution cuts (see It’s the Distributions, Stupid!), alienating income-seeking investors.

Regular readers know the story, which is recounted in the links above.

Many would regard the chart below as confirming the high correlation between midstream and crude that they know to be the case. In fact, the correlation since the beginning of last year is 0.21, positive but not that meaningful. The nature of the calculation is that brief periods of sharp opposite moves have an outsized effect on the resulting number, compared with what a casual glance at a chart might imply.

The latter half of 2018 was probably one of the most frustrating periods for investors in recent years. Crude oil rallied strongly during the summer, while midstream stocks slumped. In the fall, crude fell sharply as the stocks continued falling. Statistically, the summer’s negative correlation followed by a positive one in the fall resulted no correlation for the entire period. But investors, reasonably enough, recall the period with more feeling than the statistics might suggest.

The answer is that midstream energy infrastructure tends to move with the overall energy sector – not surprising, since the E&P names are its customers. The S&P Energy ETF (XLE) moves with crude, which drives sentiment. Natural gas and associated liquids are more important than oil to pipelines but daily gyrations have little effect.

Questions on how the sector will hold up if interest rates rise are less common. Perhaps investors have tired of worrying about rising rates. Or maybe the sector volatility in recent years has pushed away many income-seeking investors.

The recent stumble in sectors that had long outperformed (see Momentum Crash Supports Pipeline Sector) coincided with a jump in bond yields. In the first two weeks of September, yields jumped 0.4%. But midstream stocks rallied, since fund flows were dominated by a shift to value and comparative yield spreads mattered little.

We think the attack on Saudi Arabia’s oil infrastructure (see Saturday`s Attack Is A Game Changer) favors U.S. exporters of oil and gas by highlighting the risk of supply disruption out of the Persian Gulf. But putting geopolitics aside, WeWork’s aborted IPO set the negative tone for momentum stocks. Perhaps the correlation that matters is the negative one between unicorns and tangible energy infrastructure.

Saturday’s surprise attack on Saudi Arabia’s Abaqaiq oil facility in Buqyaq has sent crude oil prices sharply higher. There are estimates of up to 5.7 Million Barrels per Day (MMB/D) of lost output. For perspective, the last two big drops in crude oil, in 2008 and 2014-16, were caused by around 2% excess supply. The lost Saudi output, half of what that country produces, represents around 5% of world demand.

It’s unclear how long it will take to repair the damage. Estimates are at least several weeks. Saudi Arabia has assured buyers that deliveries will be augmented from crude kept in storage.

Regardless of where crude prices go, owning energy infrastructure in the U.S. looks a bit smarter (see U.S. Insulated From Possible

Landscape image of a oil well pumpjack wiith an early morning golden sunrise and American USA red White and Blue Flag background.

Supply Shock After Saudi Attack). U.S. production is decentralized, making it virtually impossible for a single attack anywhere to disrupt a significant portion of output. And while terrorism remains a relentless threat, the U.S. has shown it is able to protect its vital assets.

Although crude oil prices will initially provide a lift to the perennially downtrodden midstream energy infrastructure sector, we think investors will reassess sources of energy supply based on stability. This should provide more enduring support to a business that is wholly based in North America, far removed from the world’s unstable regions and increasingly the world’s marginal producer.

Much of the world’s energy comes from politically unstable parts of the world (see Investors Look Warily at the Persian Gulf). The Shale Revolution has provided America with more geopolitical flexibility to pursue its aims without worrying about OPEC cutting supplies (see U.S. Plays Its Foreign Policy Hand Freed From Oil). Growing domestic production gives America greater control over its economy (see Shale Security).

Midstream energy infrastructure, which supports American energy independence, is a clear beneficiary of the weekend’s news.

The end of August was the five year anniversary of the peak in MLPs. Had it not been for the distraction caused last week by a more compelling story (see Blackstone and Tallgrass Further Discredit the MLP Model), we would have already noted this milestone.

The Alerian MLP index, albeit much changed and diminished since August 2014, remains 38% lower including dividends. We won’t repeat the reasons, which are familiar to regular readers (see It’s the Distributions, Stupid!).

Pipeline stocks have certainly labored under some poor management decisions (see Kinder Morgan: Still Paying for Broken Promises) and self-dealing (see Why Energy Transfer Can’t Get Respect). However the Blackstone take-private offer for Tallgrass (TGE) plays out, this unfortunate episode has confirmed the wariness of many investors for the weak governance of publicly traded partnerships.

But the broad energy sector also languishes, now representing less than 4.5% of the S&P500. The S&P energy ETF (XLE) is 42% off its highs of June 2014. The Van Eck oil services ETF (OIH) is down a staggering 83%. The sustained weakness in the pipeline sector has to be considered against this backdrop. Even Exxon Mobil (XOM) is 25% off its April 2014 high, and yields over 5%. For the first time in the history of the S&P500, XOM is not in the top ten.

Energy investors are keenly aware that, although their sector bottomed in February 2016 along with crude oil, the broader equity market has risen over 50% from that low point. The S&P500 is within 2% of new all-time highs.

Holders of midstream energy infrastructure stocks are clearly not momentum investors. But they have identified relative value – the chart below highlights that relative P/Es compared with the S&P500 favor MLPs more clearly than during the financial crisis, or even the February 2016 low which capped an even bigger drop than in 2008-9.

P/Es rarely even figure in evaluations of MLPs, since earnings are often distorted by depreciation charges that don’t reflect the actual change in value of owned assets. So it’s notable that even using earnings numbers that are usually lower than Distributable Cash Flow (DCF), the sector is cheap.

In discussions with investors, we continue to find that growth in free cash flow is the strongest bullish case. The chart below (also see The Coming Pipeline Cash Gusher) is based on the American Energy Independence Index, which provides broad exposure to North American corporations along with a few large MLPs. Existing assets are generating increased DCF, and investment in new projects peaked last year. We revise these projections quarterly based on guidance during earnings calls, and so far the numbers are approximately tracking what we expected when we first projected FCF in April.

There can be few areas of investing as unloved as energy. Investors may be put off by past distribution cuts, poor capital allocation decisions, questionable governance or climate change (see  Our Fossil Fuel Future (With a Bit More Solar and Wind)).

In response: distributions are rising; growth capex has peaked; most of the sector is now corporations, with more robust governance; and serious long term forecasts recognize that fossil fuels will provide 80% or so of the world’s energy for decades to come.

Valuations and growing cashflows support a recovery in prices.

We are invested in TGE.

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).

Last week the Financial Times wrote about the dwindling conviction of believers in the Shale Revolution (see Why US energy investors are experiencing a crisis of faith). Religion is an appropriate metaphor – secular values such as Enterprise Value to EBITDA or forward free cash flow yield have offered scant protection. To invest in energy today is to be a Christian thrown into Rome’s Coliseum.

In January Blackstone Infrastructure Partners (BIP), invested $3.3BN for a controlling interest in Tallgrass Energy (TGE) which, following a simplification of its GP/MLP structure left Blackstone owning 44% of the company. On Tuesday night TGE disclosed a take-private offer from BIP for the rest of TGE. It’s a measure of how poorly TGE’s stock has performed that buying the remaining 56% would cost $200MM less than BIP’s original investment even after the 35% premium embedded in the proposal.

The good news came with a sour taste. A previously agreed sideletter between BIP and TGE came to light revealing a sweetheart deal for management. In the event of a take-private transaction like this one, management can sell its shares at $26.25, not the $19.50 agreed for all the public investors. A cynic might conclude that TGE allowed uncertainty about their capex plans and recontracting on pipelines to weigh on the stock price, inviting BIP to acquire the balance below their earlier deal price while paying insiders 35% more. Energy sector executives provide ample material for critics who see scant evidence of a fiduciary mindset.

Returning to negative sentiment, retail investors struggle with the failure of growing oil and gas production to lift the prices of midstream energy infrastructure, with its toll-model supposedly fairly insulated from commodity prices. Public market valuations differ from where private equity sees things. It turns out  BIP is also puzzled but happy to exploit the opportunity.

They’re not the only private equity investor to have misjudged the depth of public market antipathy to energy. Last year Global Infrastructure Partners (GIP) invested $3.125BN to acquire a controlling interest in Enlink Midstream (ENLC). Following their GP/MLP simplification a few months later, GIP owned 40% of ENLC.

Today ENLC’s market cap has sunk to $3.6BN, creating a paper loss for GIP of almost $1.7BN. Former CEO Barry Davis returned, replacing Mike Garberding who had been promoted from CFO less than a year earlier. It’s not just retail investors who have bought into undervalued pipeline stocks too soon.

Earlier this year private equity firm IFM Investors bought Buckeye Partners for $6.5BN, a 32% premium to the market price.

Goldman Sachs recently noted that around $250BN in private equity “dry powder” is dedicated to infrastructure and natural resources. It won’t all find its way into the U.S. pipeline sector, but the American Energy Independence Index, which broadly reflects the sector, now has a market cap of around $450BN. The float-adjusted figure, removing shares held by management that don’t trade, is $372BN. GIP is raising a fourth fund targeting $17.5BN, undeterred by the paper loss GIP III has taken on ENLC.

The end of August marked the five year anniversary of the peak in the Alerian MLP Index. It remains 39% off its high. Hinds Howard, who follows the sector for CBRE Clarion Securities, notes more than 80 constituents have been removed from the index. MLPs have steadily become less representative of midstream energy infrastructure. The Alerian MLP Index (AMZ) has a market cap of around $250BN ($150BN float-adjusted).

The FT article blamed the slump in part on poor spending discipline. By way of confirmation, PDC Energy’s (PDCE) recently announced acquisition of SRC Energy (SRCI) anticipates annual savings of $50MM in General and Administrative (G&A) expense. Considering SRC’s entire G&A was $39MM last year and the company’s market cap is $1.1BN, this is not a company with a parsimonious culture towards corporate overhead. Both stocks rose on the news.

Investors want further consolidation in the energy sector, including midstream. There are more senior energy executives than we need.

We are invested in ENLC and TGE.

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).

Infrastructure projects can require a lot of planning, but the proposed link by the Alaska – Alberta Railway Development Corporation (A2A Rail) traces its roots back to 1898, when a charter to build a line to Alaska was awarded to the Edmonton & District Railway Company. Canada is perennially challenged to move its bitumen-based crude oil to export markets. Progress on the Keystone XL suffered years of delays. It’s designed to move crude from Alberta to Cushing, OK. Environmental activist opposition under Obama at one point caused TC Pipelines (TRP, then called Transcanada) to take a C$2.9BN writedown in 2016.

The obvious move was Trans Mountain (TMX), an expansion pipeline within Canada to the Pacific coast for export. But this caused such acrimony between Alberta and neighboring province British Columbia that Kinder Morgan Canada eventually gave up, selling the project with fortuitous timing to the Canadian federal government.

Enbridge (ENB) recently told us they wouldn’t attempt to build a new oil pipeline in Canada, unless it was wholly within energy-friendly Alberta.

Against this backdrop, there’s a resurgence of interest in moving crude by rail to export facilities in Alaska. It’s a measure of the unintended consequences of environmental extremists that a higher-cost, riskier route is being pursued. Alberta’s oil production exceeded the takeaway infrastructure so significantly that the provincial government imposed production constraints. Last year the benchmark Western Canada Select (WCS) traded as much as $30 per barrel below the WTI benchmark, ruinous testimony to Canada’s domestic transport constraints. Getting its oil to markets has created fissures within Canada. Albertans feel their net contributions to the Federal budget are unappreciated by the rest of the country.

Few Canadians will soon forget the 2013 crude train disaster in Lac-Magentic, when a fireball engulfed a small town in Quebec, killing 47 people. Pipelines’ better safety record is ignored by opponents of today’s energy, hence reconsideration of the railroad.

The Alberta – Alaska Railway (A2A) will run from Edmonton and Fort McMurray, in the heart of Alberta’s tar sands region, carrying 1-1.5 million barrels a day of crude to the ports of Alaska’s south central coast. It’ll link up with the Trans Alaska Pipeline System, which accesses Alaska’s North Slope oil reserves. Proximity to Asian markets shaves four days off the shipping time compared with ports in the Gulf of Mexico, home to North America’s crude export terminals.

A2A will pass through Canada’s Yukon territory, a remote and resource-rich area. Supporters note that extracting Yukon’s valuable minerals will become more commercially attractive with access to railroad transport. Flexibility is rail’s main advantage over the pipelines, which offer safe, specialized transport just for liquids and gas. Copper, lead, zinc and uranium could be mined and linked by an extension to the A2A, boosting local employment in a sparsely populated and relatively poor region. By promoting benefits beyond global access for Alberta’s crude, the project is aiming for broad support.

A2A may even provide alternative rail shipment for Asian goods coming into the U.S.

The cost is estimated at C$14-20BN, and should find eager investors among the many private equity funds dedicated to infrastructure. Robert Dove, Head of Financing and Strategy for A2A Rail, said, “We anticipate institutional investors will find the long term cash generating ability of the railway to be highly attractive. By providing improved access to export markets for Canadian crude oil as well as developing important mineral reserves in the Yukon Territory, we think there are multiple revenue opportunities for this important infrastructure project.”

In June, A2A Rail reached agreement with the Alaska Railroad Corporation on working together to build the connection. Stakeholder consultations come next, including negotiations with the many indigenous tribes known collectively as First Nations. In many cases opposition can probably be softened with community investments. 121 years after first being contemplated, a railroad from Alberta to Alaska took another step towards reality.

Although there seem to be countless stories about the demise of fossil fuels because of climate change, projects such as A2A reinforce that oil, gas and natural gas liquids will continue to provide the vast majority of the world’s energy for decades to come.

We are invested in ENB and TRP.

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).