New pipelines are becoming harder to build. New York recently blocked a natural gas pipeline planned by Williams Companies (WMB) because of environmental concerns, although WMB plans to reapply. Canada is becoming a more difficult and expensive place in which to build (other than in oil-rich Alberta). Enbridge (ENB) went as far as to say they wouldn’t attempt a new, greenfield crude oil pipeline in Canada. They regard the permitting process as capricious, hijacked by a small minority of vocal environmental activists that don’t reflect the public interest.

Impeding new construction simply increases the value of the existing asset base. It also means that today’s dominant firms will maintain their market positions in the future; this is not an industry where a disruptive start-up has realistic prospects.

It also creates an unusual alignment of interests between anti-fossil fuel, environmental activists and investors who are clamoring for a greater return of cash to owners. Both are opposed to new spending, albeit for different reasons.

Tellurian (TELL) is developing a Liquified Natural Gas (LNG) export complex. Their unusual financing model involves raising equity capital from customers. In this way they share some of the project’s upside and create key long term partnerships. They see growing Permian crude production leading to a huge jump in associated natural gas output, creating the need for an additional 20 Billion Cubic Feet per day (BCF/D) of LNG export capacity.

Incidentally, in a panel on LNG, Andy Orekar of Gaslog Partners said that if all the world’s shipping converted to LNG (because of the impending IMO 2020 standards on maritime emissions) it would consume more than all of the current trade in LNG. Currently, gas-powered ships are limited to LNG tankers that consume a small portion of their cargo for power. It’s a theoretical point since the industry is installing sulfur scrubbers and switching to cleaner crude oil-based fuels, but an interesting one nonetheless.

Today the U.S. exports around 4 BCF/D. Because natural gas is an inevitable byproduct of crude production in the Permian, TELL expects the economics of oil to drive more gas output which will need to be sent somewhere. They believe the Permian may produce as much as 30BCF/D, creating a need for almost all proposed LNG projects. Increased domestic consumption and pipeline exports to Mexico will only soak up so much, with seaborne LNG exports being critical to avoid constraints on crude production. Flaring unwanted natural gas is limited, and the larger companies that are now dominating Permian activity are especially likely to avoid the negative publicity associated with such obvious waste.

Private equity has developed into an alternative source of financing for midstream infrastructure since public market valuations essentially render equity financing prohibitive. This highlights the contrast between how public and private markets view the sector. Although private funds can compete effectively for projects, it’s also made exits harder, leading to longer holding periods that can reduce returns. The traditional arbitrage, in which public buyers acquire assets at higher multiples than paid by private equity, is currently being reversed. This reflects the continued public market wariness of midstream energy infrastructure, and highlights currently attractive valuations.

Most firms now have a set of policies covering ESG (Environmental, Social and Governance). This is regarded by some as a requirement for drawing in generalist investor interest. One company noted that European investors were more likely to use ESG as a screening metric, and reported that they had seen a notable pick up in interest from non-traditional investors in response to their adopting ESG policies. Mentioning Energy Transfer (ET) in the context of ESG invariably draws a chuckle (see Why Energy Transfer Can’t Get Respect)

A meeting with Enterprise Products Partners (EPD) produced some useful insights. They regard U.S. crude oil export infrastructure as still catching up with volumes. Building a facility to accommodate Very Large Crude Carriers (VLCC) is an important objective for them. The application to build this terminal was 13,000 pages and weighed 100 lbs.

EPD also sees very strong Chinese demand for U.S. exports of ethane and propane, with the current trade dispute not regarded as a long-term problem.

The “War on Plastics” led them to point out the slide shown below, which highlights how much of global plastics pollution can be traced back to ineffective disposal among some Asian countries.

Overall, the news was good and growing free cash flows are beginning to draw interest from a wider pool of investors. We left with reinforced conviction that valuations are excessively pessimistic. Strong returns lie ahead.

We are invested in ENB, EPD, ET, TELL and WMB.

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).

Warren Buffett likes the Permian Basin. This was clear from Berkshire’s (BRK) proposed $10BN preferred investment in Occidental (OXY) should they buy Anadarko (APC). Berkshire’s annual shareholder meeting was followed as usual with a Becky Quick interview on CNBC.

The 8% dividend on the preferred OXY will issue to finance their acquisition could be inducement enough for BRK to commit $10BN. When Becky commented on this Buffett responded “It isn’t great to have an 8% preferred if there isn’t any oil there.   It’s a bet on oil prices over the long term more than anything else and it’s also a bet on the fact that the Permian basin is what’s it’s cracked up to be. … You have to have a view on oil over time and Charlie and I have got some views on that.”

This led Becky to ask why BRK didn’t use some of its cash hoard to buy Anardarko for $35BN, to which Buffett replied “Well, that might have happened if Anadarko had come to us.”  Buffett was quick to clarify that he wouldn’t jump in to a bidding war with someone who has come to them for financing. Buffett wants more supplicants for similar deals. But it does show that they see value in the Permian Basin, OXY and APC.

The competition between Chevron (CVX) and OXY to buy APC provides further confirmation of a bullish production outlook among those with the best information. CVX and OXY were the two biggest producers in the Permian last year, each pumping over 300 thousand barrels per day (MB/D). APC did 100 MB/D. They know the region. Rystad Energy believes that a CVX/APC combination would reach almost 1.4 Million Barrels per Day (MMB/D) in output by 2025. A match-up of OXY/APC would get to 0.9 MMB/D. Permian volumes are growing fast, and the influx of additional capital makes this even more likely. Midstream energy infrastructure is a sure winner.

As always, Buffett had some wonderful folksy quips. In discussing his 60-year partnership with Charlie Munger, he noted that they’d often disagreed but never had an argument. Munger sometimes concludes such debates with, “You’ll agree with me soon, because you’re smart and I’m right.”

Try using that at home with your significant other. Let us know how it goes – we’ll publish any credible stories.

Buffett and Munger aren’t overly concerned about the latest ratcheting up of trade tensions. They believe both sides will benefit from concluding a deal. We agree that trade tensions are unlikely to be a factor entering 2020 when Trump is running for re-election (see The Trump Put).  One easy way to reduce the trade deficit is for China to increase it’s purchases of raw materials from the U.S. This could include huge amounts of LNG, natural gas liquids such as propane, and light crude oil that they desperately want and need.

If the dispute is drawn out, planned Chinese purchases of U.S. Liquified Natural Gas (LNG) are at risk. But LNG is fungible, and U.S. exports could displace trade to other Asian countries whose shipments would in turn head to China. Cheniere Energy (ticker: LNG) and Chinese energy firm Sinopec are planning a 20 year LNG deal once the trade negotiations are concluded.

While a full-blown trade war that severely damages global GDP growth can have a meaningful impact on oil demand and oil prices, a resolution should boost demand and clear the way for Chinese buyers to sign long-term contracts from U.S oil and gas exporters.

Moreover, the U.S. just dispatched aircraft carrier Abraham Lincoln to the Persian Gulf so as to, “send a clear and unmistakable message to the Iranian regime…” The Shale Revolution has improved America’s ability to press our interests since we are so much less dependent on Middle East oil. Trump is not one to shy away from a fight. We won’t forecast how events with Iran will play out – but domestic energy investments are one of the safer places to be if there is conflict with Iran.

With historically low valuations for the energy sector, record oil & gas production, and solid growth prospects, the weekend’s news is showing energy to be one of the most overlooked areas in the market.

We are long BRK.

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).

Pipeline company earnings are being scrutinized for capital investment plans.  The energy sector’s pursuit of growth has been well covered. Investors would prefer less excitement and more return on capital through dividends and buybacks. Company management teams are for the most part grudgingly co-operating.  Targa (TRGP) CEO Joe Bob Perkins defiantly described growth projects as “capital blessings”. TRGP promptly dropped 5%. Owners want more cash returned.

Distributable Cash Flow (DCF) is the cash return from existing assets. REIT investors know it as Funds From Operations (FFO), an equivalent measure. Because DCF excludes spending on new projects, it reflects steady-state cash earned before growth initiatives. This is why DCF or FFO are commonly used in evaluating businesses whose returns come from large fixed assets, such as infrastructure and real estate.

Free Cash Flow (FCF) is the net cash generated (or spent) after considering DCF, growth projects and any financings and asset sales (i.e. after everything). It’s common for companies that are investing heavily to have little or negative FCF. Investors in such stocks ultimately expect FCF commensurate with sums invested.

Exploiting the Shale Revolution has boosted growth capex by billions of dollars, both for upstream companies as well as the midstream infrastructure sector. It’s why FCF has substantially lagged DCF in recent years. Although today’s income statements don’t show it, a combination of slowing growth capex and rising DCF will cause pipeline companies to produce vastly more FCF.

We examined all the names in the American Energy Independence Index (AEITR), which provides broad exposure to North American midstream corporations along with a few MLPs. On a bottom up basis, FCF was just over $1BN last year, a paltry figure given the industry’s $514BN market cap.

The need for growth capital broke the MLP model (see It’s the Distributions, Stupid!). Their narrow set of income-seeking investors wasn’t willing to support the growing secondary offerings of equity without higher yields. Companies needed to find the cash somewhere, so four years of distribution cuts followed – for example, the Alerian MLP ETF (AMLP) has cut its payout by 36% since 2014, reflecting reduced distributions by the names in its index.

The industry is over the hump of its spending on growth projects. Analysts look carefully for “capex creep” whereby annual guidance for new spending gets revised upward during the year. But based on current bottom-up guidance for the AEITR, we expect such spending to be down 4% this year, with >20% reductions in 2020 and 2021.

Recently completed projects are starting to show up in higher DCF, which we estimate will grow by 8% this year and 12% in 2020. A 90% completed pipeline isn’t much use, and multi-year construction projects only generate cash when they’re completed and paid for.

Making more money from existing assets, while spending less on new ones, is a potent combination. By 2021, FCF is set to be close to what DCF was in 2018. Moreover, much of today’s growth is internally funded, meaning little reliance on issuing equity. Based on current guidance, Transcanada (TRP) is the only company likely to tap the equity markets meaningfully, as construction of the perennially delayed Keystone XL gets under way.

As a result, last year’s sector-wide $1BN in FCF is set to jump eightfold this year, more than triple in 2020, and increase by two thirds again in 2021. It’s why dividend growth is back (see Pipeline Dividends Are Heading Up). Our analysis assumed no new debt issuance, which therefore assumes leverage will continue to decline. To the extent that the industry maintains current Debt:EBITDA ratios by issuing more debt, FCF will grow more than our forecast.

The “bridge” chart illustrates annual FCF 2018-21 with the changes in DCF and growth capex forming the bridge from each year’s FCF to the next.

The Shale Revolution has long been described as a huge boost for America, including on this blog. Investors often complain that it’s been a far better story than an investment. The strong start to the year has been a welcome surprise to many long-suffering holders. And yet, a substantial jump in FCF is still not widely expected. The sector has plenty of upside.

We are invested in TRGP and TRP. 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).

The Alerian MLP ETF (AMLP) remains the largest ETF in the sector, in spite of its ruinous tax drag (see MLP Funds Made for Uncle Sam) and long term returns that are less than half of its index. It’s been a commercial success for its promoters but unfortunately, a disastrous investment for many holders.

However, there are signs that AMLP’s fan base is slipping. Its share count’s steady growth abruptly stopped last summer. Since then, shares outstanding are down over 8%. Half of that drop has come this year.

Midstream energy infrastructure has been a frustrating sector to be sure, and to some degree AMLP flows reflect broader investor sentiment. Through 2014 assets grew, and even during the 2014-16 energy collapse AMLP’s share count increased.

But since last summer, there’s increasing evidence of lost market share. Figures from JPMorgan show AMLP experienced 2H18 outflows of $942MM, a disproportionate share of the sector’s $2.9BN outflows during that period.

Market direction doesn’t seem to make much difference. Last year’s outflows coincided with sector weakness, but outflows have continued this year even though midstream energy infrastructure has been a leading market performer. AMLP’s 2019 outflows have roughly cancelled out inflows to other funds.

Back in 2010 when AMLP was launched, there was clearly investor demand for MLP exposure that avoided K-1s. The corporate tax drag meant AMLP, an index fund, could never come close to matching its index. Buyers overlooked or were unaware of this weakness.

Much has changed over the years. MLPs used to be synonymous with pipelines, but the limited investor base has led many large companies to convert to corporations. Today, North American midstream energy infrastructure is two thirds corporations by market cap (see Pipelines’ New Look).

The MLP structure remains tax-efficient, but its income-seeking investor base has proven to be a fickle source of equity capital. So those MLPs that remain, such as Enterprise Products Partners (EPD), do so because they don’t need to issue equity. There were no MLP IPOs in 2018. Blackstone recently announced plans to convert from a partnership to a corporation, concluding that the K-1s were not worth the trouble.

The shrinking pool of MLPs reflects this change (see Are MLPs Going Away?). AMLP’s 100% MLP exposure omits many of the biggest pipeline corporations.

AMLP also holds an ignominious position on the Top Ten “Money Burned” ETFs posted on Twitter recently. The sector’s poor performance has a lot to do with this, but the corporate tax drag on top of poor results was enough to gain AMLP entry to the list.

The steady erosion of AMLP’s investor base suggests that investors are starting to acknowledge the ruinous tax drag and the switch away from MLPs to corporations.

Since AMLP holders are deciding to exit, it suggests that MLP prices will continue to experience downward pressure relative to corporations, a trend that has been well established this year. The sector is cheap, but broad energy infrastructure exposure that includes corporations will continue to deliver better results than a narrow, MLP-only approach. AMLP owners should sell, probably taking a tax loss, and move into a more diversified product.

Regular readers will be familiar with our blog posts on the topic, and so now are many investors.

 

We are invested in EPD and 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).

Chevron (CVX) CEO Mike Wirth must have used the term “short-cycle” at least half a dozen times on Friday’s conference call discussing their $33BN acquisition of Anadarko (APC). It’s a feature of the Shale Revolution that’s still unappreciated by investors, even while it’s highly valued by upstream companies. A faster capital cycle boosts returns.

The U.S. Shale Revolution has upended global energy markets, and not only because of cheap, new supply. which is already turning America in to the world’s biggest exporter of hydrocarbons. A decade ago Cheniere (LNG) was building facilities to import natural gas, and energy independence was a pipedream.

Conventional oil and gas projects used to require many $BNs in upfront capital, with a payback over a decade or more. Global GDP growth, production costs and future demand all have to be considered before a final investment decision is made. Climate change and public policy response have added to long term uncertainty for an already cyclical business.

The power of shale extraction is that capital spend is spread out and cash returns come sooner. It costs less than $10MM to drill a well, and in America we drill thousands every year. The high initial production and sharp decline rates return capital invested far more quickly. Output can be hedged because the 2-3 year liquidity of futures aligns with the cashflow cycle of shale far better than with conventional projects. If oil falls, drilling slows. It’s just less risky, which is why investment dollars continue to flow into North America.

CVX isn’t alone in recognizing this. ConocoPhillips (COP) places U.S. unconventional, or tight (as shale is often called) in the upper right of a chart with the best combination of capital flexibility and returns.

This chart from IHS Markit links high capital flexibility with fast initial production.

We have often commented on this aspect of growing domestic oil and gas output. See our short video America’s Energy Renaissance: The Short Cycle Advantage of Shale and a piece in Forbes The Short Cycle Advantage Of Shale.

Conventional projects are becoming much smaller. North America, which offers substantial short cycle opportunities, continues to draw investment. The result is that America is gaining share in the world’s energy markets. This is likely to remain the case in almost any scenario, because of shale’s lower risk profile.  Wirth went so far as to highlight that not only is shale among some of the highest return projects in their portfolio, but it’s also among the lowest risk both below and above the ground.

A slide from Enterprise Products Partners’ recent investor day highlights strong growth in Asia over the next couple of decades.

For pipeline owners, this is enormously positive. North American upstream companies are our customers. The Shale Revolution has plenty of critics who argue that Wall Street continues to provide capital, illogically, to unprofitable activities. And yet well informed investors such as CVX are concluding it’s a very attractive place to be. Last year ExxonMobil (XOM) announced plans to invest $50BN in North America over the next five years. CVX was already planning 900 thousand barrels a day of oil production by 2023 in the Permian before the APC acquisition. XOM expects to produce a million barrels per day there. These companies bring scale and stability, which makes them the most attractive customers possible for midstream energy infrastructure.

This was also positive for Western Midstream Partners (WES), since their business with APC is now likely to grow substantially. In response to a question about its new MLP, Wirth pointed to the Waha basis spread, which is negative, meaning producers are paying to get rid of their natural gas. He noted the importance of offtake and high quality midstream infrastructure, and clarified that WES was a strategic asset for them.

CVX is taking advantage of relative weakness in APC’s stock price compared with their own. Nine months ago they would have had to offer almost twice as big a premium. There were also reports that Occidental Petroleum (OXY) had offered APC $5 per share more, but that CVX’s offer was preferred because it’s regarded as a better partner.

The bottom line is that the CVX/APC deal is great news for midstream energy infrastructure. CVX’s lower cost of capital and merger synergies can only lead to higher oil and gas production than would otherwise have been the case. Pipeline stocks are poised for a significant rally. Over four years of weakness have led to distributable cash flow yields above 10% that are growing 10-15%. Dividends are rising for the first time since 2014. The sector remains over 30% below its all-time high, even while the S&P500 flirts with a new record. CVX provided further affirmation of the enduring value in U.S. unconventional production.

We are invested in EPD and WES.

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).