It usually pays to invest with management. In the hedge fund industry that has rarely been possible. Although most hedge fund managers invest in the fund they run, their wealth has come from owning the hedge fund General Partner (GP), which manages the fund. Opportunities to invest in hedge fund GPs are rare; they don’t need your capital and have little desire to share the lucrative economics.

In 2012 I wrote The Hedge Fund Mirage; The Illusion of Big Money and Why It’s Too Good To Be True. The book pointed out what most hedge fund managers know – that hedge funds have been a great business and a lousy investment. Fees have eaten up virtually all the investment profits. Money still flows to hedge funds, because there are and always will be some good ones. But the farther you stray from a unique, specialized strategy the more prosaic your returns. The book drew some nice reviews and provoked few critics, because most industry insiders preferred to minimize awareness of the lopsided split of investment returns. Being controversial turned out to be great fun, and caused us to think differently about another asset class.

Master Limited Partnerships (MLPs) look like hedge funds. Although they own actual infrastructure assets rather than stocks, bonds and currencies, they share their organization as partnerships with hedge funds and private equity. MLP investors, like Private Equity (PE) fund investors, have limited rights. They’re called “Limiteds”, because Limited Partners (LPs) have little recourse once they’re invested (see The Limited Rights of Some MLP Investors).

Not all MLPs have a GP, but many do and given how well hedge fund managers have done it’s no surprise that the people who run MLPs prefer to invest in the GP. The issue doesn’t receive much attention, but research we’ve done shows that in a select group of MLPs (i.e. those we care about) management has 25X as much money invested in GPs versus LPs.

Hedge funds and PE funds classically pay their GP “2 & 20”. This 2% management fee and 20% of the profits means, for example, that an 8% return after fees required a 12% return before fees. The 4% difference goes to the manager. MLPs pay their GPs Incentive Distribution Rights (IDRs), which direct a portion of the MLP’s Distributable Cash Flow (DCF) to the GP. The DCF split typically starts low but goes up to 50%, so the GP’s share can tend towards half.

The power of this becomes clear when you consider the financing of a new pipeline. GPs direct their MLPs to do something, the same way a PE manager directs his PE fund. A new pipeline is designed, planned, built and operated by an MLP on instructions from its GP, who then receives his share of the additional DCF created. Asset growth for PE managers is invariably beneficial, and it’s generally true as well for MLP GPs.

The best time to own hedge fund, PE or MLP GPs is during periods of asset growth. The Shale Revolution (see America Is Great!), with its growing output of crude oil, natural gas liquids and natural gas, is driving the need for more infrastructure assets. Recognition of this is behind the 25X statistic noted above.

It’s not a perfect analogy. For example, hedge fund investors have in aggregate done rather poorly, whereas 10 year MLP returns of 7.2% are better than REITs, Utilities and Bonds. Since MLP’s generally only raise equity from taxable U.S. investors tolerant of a K-1, they are limited to this relatively small portion of the global equity market. Those MLPs whose growth plans required several $BN have given up the lucrative GP/MLP structure in favor of being conventional corporations. But, as the 25X table shows, a decent number find the MLP structure still works.

At the MLPA Conference in Orlando a few weeks ago, questions usually concerned near term fluctuations in demand for one asset or another. We think the big trade here is America’s Path to Energy Independence, and owning GPs that benefit from continued infrastructure development. Conference chatter as well as attractive valuations show that it’s not yet a crowded trade.

Last week was the annual MLPA conference, in Orlando, Florida. It’s safe to say the guests at nearby Walt Disney World had a more carefree time than beleaguered MLP investors. One long-time attendee described the mood as “glum”, noting that energy sector investors had expected a more vigorous rebound.

Although the conference is organized around presentations by management teams in the Hyatt Regency’s cavernous ballrooms, the private meetings that take place on the periphery are far more valuable. It’s also nice to catch up with some familiar faces.

We had a full schedule of meetings with management teams, usually with just one or two other investors in attendance. The most pressing question for MLP investors of late is, if Exploration and Production (E&P)  companies (i.e. MLP customers) are continuing to increase production of oil and gas, why isn’t this good for MLP stock prices?

In fact the entire energy complex has had a terrible few months. MLPs are -2% YTD although the sector feels as if it’s been falling for months. Meanwhile, the Oil Services ETF (OIH) is -22%. U.S. crude output is 9.2 MMB/D (Million Barrels per Day) and is widely expected to reach 10 MMB/D next year by many observers, including OPEC. 1Q earnings for E&P names as well as for MLPs recently were generally good with positive guidance. The fundamentals remain encouraging . To paraphrase a typical question from a financial advisor invested in our mutual fund, “If you’re so smart, how come we’re losing money lately?”

When asked about recent stock price weakness, MLP executives were similarly puzzled. The good news is that they’re not spending much time worrying about it – following the 2015 Crash many steps were taken to reduce reliance on the fickle equity markets. Leverage is down and distribution coverage is up. Distributions have been held flat and in some cases cut in order to finance growth, while growth projects have been screened for higher returns. Generally, MLPs don’t have a pressing need for capital. While stock price weakness makes both management and investors poorer, it’s not being met by a desperate rush for capital to complete projects. And in some cases, such as Targa Resources (TRGP), equity capital even at lower prices was nonetheless attractive financing for their recently announced Natural Gas Liquids pipeline from the Permian Basin to North Texas.

In short, management teams usually exuded excitement about greater utilization of their existing infrastructure and growth plans. They dismissed the high recent correlation between MLPs and crude oil as a temporary phenomenon and not reflective of improving midstream fundamentals. For investors who rely on the market to confirm the wisdom of their recent decisions, it’s a time for patience while America’s journey to energy independence sends ever more hydrocarbons through our pipelines, processing units and storage facilities.

We enjoyed the discussion with Tallgrass Energy (TEP) CFO Gary Brauchle. We’ve followed TEP for a while (see Tallgrass Energy is the Right Kind of MLP). Four years ago their Rockies Express natural gas pipeline (REX) looked increasingly redundant as its west-east flow from the Rocky Mountains to Ohio faced growing competition from the Marcellus shale. TEP reversed the flow on the eastern end of this pipeline, and is looking at making the entire line two-way. Apparently our meeting was the same day as a bearish report from an obscure research analyst, but his criticisms must have lacked substance since nobody raised the subject.

The MLP investor base has changed in recent years. Pre-Shale, it was an income generating asset class with modest growth. The Shale Revolution created a substantially greater need for capital to fund growth, such that during 2010-13 MLPs were raising more in equity than they were paying out in distributions (see The 2015 MLP Crash; Why and What’s Next). The conversion of the investor base from income seeking to growth seeking was not smooth. One CEO estimated 75% turnover in his shareholders over two years.

Topics of discussion included the drop in attendance from last year, although the convention facility is so big it rarely seems crowded. There was some surprise at the pricing of Antero Midstream GP’s (AMGP) recent IPO, with a yield of 1%. Even with the 73% annual distribution growth forecast by one underwriter, by 2020 it would still yield just over 5%. They may pull it off, but sharing some of that execution risk with an eager set of IPO investors seems like a smart move.

Those who had seen the presentation from the IPO roadshow chuckled at the inclusion of SnapChat as a comparable (because of its very high cashflow growth). We thought that, along with the pricing, betrayed a fairly demeaning view of investors by management. It seems most things need to go right for AMGP, and a stumble will expose the gulf in valuation between AMGP and, say, Plains All American (PAGP) with its 10% Distributable Cash Flow (DCF) yield. If MLPs were in a bubble, AMGP would be Exhibit 1, except they’re not.

In chatting about Energy Transfer, several investors remembered last year’s self-dealing transaction in which Energy Transfer Equity (ETE) issued preferential securities just to the management team (see Is Energy Transfer Quietly Fleecing its Investors?). It’s still possible a Delaware court could rule against ETE and order the transaction be cancelled.

In many of the meetings managements were peppered with very granular questions about percentage utilization of a particular asset next quarter. These generally came from sell-side analysts looking to refine their models so as to forecast the next quarter’s earnings and DCF. No doubt these are important topics, but we feel such “forest for the trees” questions miss the big picture. America is heading to Energy Independence, and midstream infrastructure is vital to that goal. In the near term, it might seem important to try and forecast a quarterly fluctuation, but it’s very hard to do so consistently.

Far more importantly, over the next few years what other asset class can possibly compete when America is headed towards being the world’s biggest crude oil producer (see America Is Great!)? Last November OPEC lost, and consequently our E&P companies are gaining market share. The short-cycle projects that are Shale represent a completely different risk paradigm to conventional drilling with its inherent uncertainty over returns (see Why Shale Upends Conventional Thinking). Gathering and Processing networks with their close exposure to the wellhead are more exposed to volume uncertainty in the short term, but over the longer term they’ll be utilized. These are the issues that will drive returns, and while most investors are probably aware of the big picture their questions often betrayed a blinkered view.

MLP management teams hold substantially more money in GPs compared with MLPs when given the choice within the GP/MLP structure. What could be a more powerful statement about the upside they see than their personal investment in the vehicles with operating leverage? The managements of Energy Transfer Equity (ETE) and TEP are communicating their opinions with their commitments of personal capital (see table at the end of The Limited Rights of Some MLP Investors).

In discussing their allocation to MLPs, I often ask investors what is the next most attractive sector of the equity markets beyond energy infrastructure, with its huge tailwinds, substantial future growth and 7% yields selling at 30% off its 2014 all-time highs. It doesn’t require much thought to buy what’s rising, but not much else is cheap.

In summary, value-seeking investors should draw comfort from the complete absence of irrational exuberance at this year’s MLPA conference. Today’s MLP investors are for the most part a patient bunch.

We are invested in ETE PAGP, TEGP (the GP of TEP) and TRGP

With the resurgence in U.S. crude oil production over the last year, it was only a matter of time until shale output reached a new record. Based on recent actual production and the EIA’s forecast for a June increase of 122 MB/D (thousand barrels a day), the peak of March 2015 is only 57 MB/D away.

The Permian Basin in West Texas has been the principal driver of this increase in production. The depth of the play, as illustrated in the slide from a recent presentation by EOG (displayed above), holds substantial reserves and has benefited from extraordinary improvements in efficiency by the operators there which has brought down break-even levels. Many have underestimated the ability of the U.S. private sector to harness technology as effectively as they have. This is activity that OPEC expected to choke off through a ruinously low price of oil. Instead, they were forced to switch gears last November and concede steadily increasing market share to U.S. producers. Recently, OPEC quietly raised their 2018 forecast of total U.S. oil production (shale and conventional) to 10 MMB/D (million barrels a day). Given the capital being invested by drillers it’s plausible that by 2018 the U.S. could be the world’s biggest crude oil producer.

The most visible recent pipeline protest was against Energy Transfer’s (ET) Dakota Access Pipeline (DAPL) earlier this year. One of President Trump’s first actions was to correctly overturn an Obama-era executive order blocking its completion. But public demonstrations against fossil fuels continue elsewhere, even if their mentally agile adherents comfortably drive to join their friends in shouting against oil and natural gas.

As a consequence, managements of energy companies are recognizing that they need a strategy to deal with such protests, since a delayed pipeline can quickly become costly. At their Investor Day earlier this month, Williams Companies (WMB) CEO Alan Armstrong discussed their evolving attitude towards groups that seek to frustrate the implementation of infrastructure projects. Striving to learn from ET’s experience with DAPL, Armstrong described a policy of actively engaging with opponents to find common ground. He also noted the potential of other groups, such as construction unions keen for the jobs, to line with WMB in pushing projects forward.

Expect to see more savvy use of media by energy companies, including video of American workers making America Great accompanied by fast-paced, inspiring music. The WMB Analyst Day included a couple of short clips. Here’s another on WMB’s blog page (called “Pipe Up”), extolling the benefits of their Northeast Supply Enhancement project.

The education of investors about tax-inefficient MLP funds received a welcome boost from Barron’s. A letter from Mike Flaherty noted the tax drag on many poorly structured MLP funds included in a recent article, “Best ETFs for Income“. Flaherty correctly pointed out the value-destroying corporate tax liability incurred by AMLP and AMZA amongst others. Asked to respond, one PM blandly referred investors to seek tax advice, which is what you’d say if you ran a poorly designed fund and wished to change the subject. Barron’s hasn’t yet assigned a journalist to write on this topic, in spite of our suggestion that they’d be performing a useful service to countless MLP fund investors. But perhaps they will soon.

We are invested in Energy Transfer Equity (ETE) and WMB

A couple of months ago (see Why Shale Upends Conventional Thinking) I promised to spread constructive thoughts about Master Limited Partnerships (MLPs) across the ensuing weeks and months rather than use them all up on the first drop in prices. Two months and several percent later such parsimony was well advised. If your preference is to invest with a stop-loss, thus ceding to others the timing of your exit and avoiding the need to think too hard, MLPs may not be your best choice.

Lower oil prices may lead to lower U.S. output (although it hasn’t happened yet) and consequential pressure on the owners of infrastructure as excess pipeline and storage capacity build. If the 2015 MLP collapse was an epic, 2017 is so far a single episode in a mini-series of unknown length.

The bear case is plain enough. U.S. oil production remains stubbornly high (at least from OPEC’s perspective). Since crude oil is now below the price that prevailed when OPEC shifted strategies, U.S. shale output is more than offsetting last year’s agreed production cuts. The agreement is being surprisingly well respected with few reports of cheating. However, while OPEC members are complying with production cuts their exports remain at previously high levels, drawing down inventories. ClipperData’s Matt Smith pointed this out last week, adding that April was the first month when Saudi Arabia cut exports in what may presage a more meaningful reduction in global supply.

A certain amount of self-confidence is necessary to buy securities that others are selling — how else does one buy, anyway? But just because one is bullish does not render the naysayers stupid. If crude oil falls far enough production in the U.S. and elsewhere will slow. Shale drillers are not immune to prices, and in fact are better able to respond than most due to the short-cycle nature of their projects (see What Matters More, Price or Volumes?). The secular improvements in horizontal drilling and hydraulic fracturing are relentlessly lowering break-even prices for the Exploration and Production (E&P) companies that are active there. These E&P firms are the customers of MLPs, so we care very much about their success.

There is a type of circular irony here, in that continued growth in U.S. output aided by productivity improvements is causing energy sector stocks to weaken. The very success of shale in America ought to be a problem for others, not for domestic E&P companies or the MLPs serving them. For now, production and price are negatively correlated – shale supply stubbornly refuses to surrender to lower prices. Or more realistically, efficiency improvements maintain production higher than it might otherwise be but nonetheless lower than would be the case at, say, $60 a barrel.

Production may slow and the worriers be proven right. So let’s complicate matters by considering a number of facts shared in the many earnings reports over recent days.

EQT Corporation (EQT) reported lower than expected natural gas output because, as CEO Steven Schlotterbeck explained, “A couple of our frac contractors decided to pay us the penalties to take their frac crews to jobs that were more profitable.” In other words, demand in the Permian in West Texas is sufficiently strong to induce frac suppliers to break contracts in the Marcellus, in Pennsylvania.  Think about this, you have a profitable shale well that you wish to drill and have contracted a crew to drill it and instead they pay you a penalty not to drill the well because economics are that much better elsewhere.

There are many indications of new capital being invested in shale drilling. Western Gas (WES) reported that their sponsor Anadarko (APC) had sold Eagleford and Marcellus assets in 1Q17. WES owns infrastructure supporting these plays, and as a result CEO Benjamin Fink said, “we therefore expect increased drilling activity behind each system.”

Similarly, ENLK’s Barry Davis noted of their sponsor, Devon Energy (DVN), “Devon recently announced the potential divestiture of certain properties in Johnson County, an area that was not competing well for ongoing capital investments in their portfolio, from an EnLink perspective, we could benefit from a transition of those assets from Devon to a producer who is committed to developing the area over the long term.”

APC and DVN are not short of investment opportunities, but are concentrating their capex budgets on their best ones. They’re evidently finding interested buyers in assets whose sale proceeds will finance even more profitable opportunities. The new money will work those assets harder than the previous owners, which WES and ENLK see as good for them. In commenting on the Permian, ENLK’s Barry Davis further noted, “In the core areas where we are positioned, oil weighted breakeven prices or (sic) around $30s per barrel making economics very attractive, at today’s prices the resulting rates of return are in the range of 80% to 100%.”

Early last year, during what turned out to be the late stages of the MLP MOAB (Mother Of All Bears), we looked at Crestwood (CEQP) and their bankrupt E&P customer Quicksilver Resources (see How Do You Break a Pipeline Contract?). Owning a pipeline that supports a play whose owner can’t pay his debts is not what MLP investors like, and some wondered if CEQP would wind up owning infrastructure that was under-used or repriced.

Quicksilver’s assets were sold in bankruptcy court to Bluestone Natural Resources. Fifteen months later, CEQP’s CEO Robert Phillips commented, “And finally, in the Barnett, Bluestone our new producer has been running a very active work over program, consistent with what we are seeing from other producers in the Barnett as well these very inexpensive work over programs are high return, expenses for the producers. And we are continuing to see volumes over and above our estimates work over program led to a 4% volume increase over the fourth quarter and the first quarter.”

As we saw before, financial distress for an E&P company need not lead to production cuts, but can instead result in a more efficient owners maintaining or even growing output.

The oil futures curve provides an interesting perspective. Falling MLP prices suggest lower crude prices will ultimately cut shale output and reduce the use of existing and planned infrastructure. But in fact deferred futures contracts have fallen farther, which only makes sense if the market expects shale output in 4-5 years time to continue being an important source of supply. If the prospects for the shale industry were dire, oil traders would bid more for longer term contracts expecting to profit from ultimately less U.S. production. But in fact they’re doing the opposite, suggesting oil traders wouldn’t short the U.S. shale industry.

Predicting the short term moves in MLPs will inevitably require being an oil trader. Your weekly blogger cannot change that. But studying the earnings reports,  transcripts and futures market over the last couple of weeks does offer a more granular perspective on the many positive developments taking place in U.S. shale.

We are invested in CEQP, ENLC (GP of ENLK) and WGP (GP of WES)

We’ve had a number of questions over the past 24 hours about the impact of the White House tax proposal on Master Limited Partnerships. Therefore, we’re posting our thoughts now rather than in our normal Sunday morning missive.

There’s not a great deal of specifics so far, but we’ve put together a table illustrating how it might impact after-tax returns for MLP investors and also how it might affect equity investors in corporations. Because MLPs are pass-through entities with no corporate tax liability, the tax reform proposal implies that the new, low corporate tax rate would apply to investors in MLPs rather than personal tax rates on investment income.

The proposed tax changes are good for most businesses. The biggest losers are likely to be taxpayers living in high-tax states such as NY, NJ or CA who currently receive significant deductions for state and local taxes (including property taxes) paid. We’ll leave that analysis to others.

For corporations, the lower corporate tax rate leaves more after-tax income to be paid to equity investors. We’ve assumed that tax rates on personal income and investment income are unchanged so as to focus in on the impact of the corporate tax rate change. We’ve also limited this analysis to Federal taxes. MLP investors often benefit greatly from deferring taxes on most of their distributions, which lowers their effective tax rate. We’ve ignored this deferral benefit as well for the analysis, although many investors (your blogger included) have MLP holdings that date back many years. But we’ve also assumed that corporations distribute all their after-tax income whereas in most cases they reinvest a portion back in their businesses and buy back stock which also defers taxes for the long term holder. Tax analysis inevitably requires making lots of assumptions.

With all these caveats, the boost to after tax income for all investors is significant, although it’s larger for MLP investors. It’s also worth noting that the relative attractiveness of MLPs compared with corporations increases with tax reform. In our example, MLP investors currently retain $60.40 from their investment versus $49.53 in a corporate structure, or 22% more. This advantage increases to 31% ($85 versus $64.77) following tax reform.

There are secondary effects too – if tax reform boosts GDP, corporate profits should rise as should energy consumption, which will drive increased demand for energy infrastructure.  Furthermore, while not specifically addressed in the proposal the administration has signaled its openness to accelerated write-offs benefiting capital intensive industries with large growth capex opportunities, such as the energy infrastructure sector.  They’ll also want to avoid creating economic uncertainty, so we shouldn’t expect contractionary moves, such as the ending of deductions for business-interest payments.

We think tax reform could provide a significant boost to MLPs by increasing the after-tax return to investors.

This blog discusses tax issues specific to MLPs. However, this is not intended to be specific personal tax advice. Each investor’s tax situation is unique and for specific advise you should seek the counsel of your own tax adviser.