The fragile mental state of MLP investors left them ill-prepared for Thursday’s ruling by the Federal Energy Regulatory Commission (FERC). By modifying how MLPs calculate certain tariffs, it sent the sector on another wild afternoon ride. It’s a complex issue – pipelines owned by MLPs that cross state lines and rely on FERC-regulated tariffs are most vulnerable. MLPs can no longer set tariffs by including taxes paid by their investors in calculating full cost of service (since MLPs are largely non-taxpayers themselves).

However, it’s possible to find many exceptions – large swathes of the U.S. pipeline network operate intrastate and are therefore generally not governed by FERC. Many contracts are negotiated or have market-based rates, and there are plenty of cases where customers have few attractive alternatives to their existing infrastructure provider. Pipelines owned by corporations rather than MLPs should be relatively unaffected, while non-pipeline energy infrastructure assets are also immune, including gathering, processing, terminals, fractionation, storage, and Liquified Natural Gas facilities.

But the ruling did provide another example of the complexity in the MLP structure. Investors have already had to contend with management teams redirecting cash flows from payouts to new projects (see Will MLP Distribution Cuts Pay Off?). MLP Limited Partners still tolerate their junior position relative to a General Partner (GP) that retains control, although the GP’s payments received via Incentive Distribution Rights (IDRs) are increasingly being phased out. K-1s have always been unpopular, and compounding 2017’s disappointing performance, users of the PWC website for electronic download are confronting additional authentication requirements that add to the burden of tax preparation.

Meanwhile, the FERC ruling exposed one more element of complexity. Calculating cost of service by including investors’ tax expense is another quirky feature of the MLP structure. Such tax rates are in any case unknowable by the MLP. The market’s superficial understanding of the issue was reflected in the sector’s initial 10% drop on Thursday before recovering approximately half, and by Friday prices were barely changed from prior to the ruling. In any event, few contracts nowadays are negotiated in such a way that FERC’s ruling affects them, compared with older, legacy contracts. Figuring in owners’ taxes turns out to be another anachronistic feature of MLPs.

Investors continue to show their disdain for the sector. Management teams long ago broke the implicit contract of stable payouts. The 30% cut in distributions since 2014 is reflected in the 40% drop in the Alerian Index. CEOs promise that much of this redirected cash will result in faster growth, and 15% annual Free Cash Flow (FCF) growth looks plausible to us. But the business model of attractive yields with little need to reinvest in the business has shifted in response to the opportunities created by the Shale Revolution. The older, wealthy Americans who were long the main MLP investor wanted their distributions, and this pursuit of growth projects has alienated them by disrupting their income. Consequently, the market is waiting to see if new projects will generate promised higher returns.

MLPs now represent less than half of U.S. Energy infrastructure, because the MLP has turned out to be a poor source of growth capital. MLPs are far from irrelevant, but they are a shrinking subset. The FERC ruling was another reason to make both investors and MLPs themselves question whether the structure is still worth the trouble. Furthermore, to be an investor in a dedicated MLP fund is to miss most of the sector as well as incur a substantial corporate tax drag (see AMLP’s Tax Bondage).  Broad exposure to energy infrastructure through a RIC compliant fund that caps MLP investments at less than 25% looks increasingly preferable.

However, there’s another class of investor that sees much to like in energy infrastructure, and that’s private equity. Although there’s limited public data available on transaction prices, these long term investors are steadily investing in long term energy assets. Blackstone acquired MLP asset manager Harvest Fund Advisors last August, in a clear bet on a resurgent asset class, having just paid $1.5BN for 32% of Energy Transfer’s Rover pipeline. Tortoise, another large MLP asset manager, sold out to a group of private-equity firms led by Lovell Minnick Partners. Other private buyers include 4 AM Midstream (acquired midstream assets from White Star Petroleum), Meritage Midstream (acquired Powder River basin subsidiary of Devon Energy), and Stakeholder Midstream (Permian gathering system).

Earnings calls often include grumbling that private equity, with its locked up capital, is outcompeting public MLPs for projects. Energy Transfer’s Kelcy Warren complained, “We lose out on projects routinely these days to private equity, not really to our peer group… there’s just a lot of private equity that hires management teams and they’re in for the short term. But it doesn’t matter, they’re winning and we’re not.”

FERC’s Thursday ruling on tariff calculations added another source of volatility to a sector not short of it. Later in the day, Enterprise Products Partners (EPD) CEO Jim Teague stated, “We do not expect the revisions to the FERC’s policy on the recovery of income taxes to materially impact our earnings and cash flow,” Other large firms soon followed, including Kinder Morgan. So the market’s initial response was disproportionate, but its vulnerability to a relatively obscure issue simply highlighted unnecessary complexity.

Energy infrastructure assets are doing fine, but the MLP entities that own them are taking a succession of body blows. The corporate ownership of energy infrastructure assets, with its access to worldwide equity investors and simpler tax reporting, is looking ever more attractive. On the week, the narrowly MLP-focused Alerian MLP Index was -2.9% whereas the broader American Energy Independence Index was -1.0%, as investors favored corporate ownership over MLPs following FERC’s ruling.

Investors in MLP ETFs such as AMLP, and similar MLP-dedicated mutual funds, already face a corporate tax drag (see again AMLP’s Tax Bondage). They are likely to see MLPs continue to lose favor as a financing vehicle, with a consequent diminution of names to hold. Investors who desire to profit from the Shale Revolution and the path to American Energy Independence should switch out of MLP-focused, tax-impaired MLP funds and into broader energy infrastructure exposure relying on simple corporate ownership of assets with no tax drag.

We are invested in Energy Transfer Equity (ETE), EPD and KMI

Last week we spent a couple of days with Catalyst Funds at their annual sales conference in Clearwater, FL. The second winter storm in a week conveniently hit the northeast after everyone had flown south, so travel plans were not disrupted. Catalyst CEO Jerry Szilagyi has been a great partner for our MLP mutual fund, and we were asked to host eight roundtable discussions with the wholesalers who market it. We have developed many great relationships with them over the years, and it was very helpful both to update them on the sector as well as to hear their feedback. Through the Catalyst network, thousands of financial advisors and other investors have become clients. As many people know, I invariably enjoy our interactions with the people whose money we invest.

Many of our financial advisor clients will be meeting with Catalyst wholesalers in the weeks ahead, and we thought it would be useful to summarize our discussions, since they’re hopefully of broader interest. Energy infrastructure investors are frustrated that record production of U.S. crude oil, natural gas and natural gas liquids is failing to boost the sector. Bad news is bad and good news doesn’t seem to help. Sector performance was the most important conversation topic.

We think the explanation lies in the split of cashflows between investor returns and new projects. This is an issue for the energy sector overall, and not just energy infrastructure companies. Complaints have been loud that too much cash is plowed back into the business, with not enough earmarked for a return on capital to investors. For the past couple of years, net share repurchases by the S&P Energy Sector have hovered at less than 1% of market capital, the worst of any of the 11 S&P 500 sectors. When combined with dividends, at 3.45% the Energy sector yield (Dividends + Buybacks) is the lowest it’s been in a decade and a little more than half of what it was three years ago.

The redirection of cashflow towards growth projects is therefore not unique to energy infrastructure. As we noted last week (see Will MLP Distribution Cuts Pay Off?), dividends on investment products linked to the Alerian MLP Index are down 30% since 2014, while the index itself is 38% off its peak. Energy managements need to show that the cash they’ve redirected has been invested wisely. For now, any new growth initiative generally receives a big thumbs down from investors.

A consequence of the need for growth capital has been the decreasing relevance of the MLP model for energy infrastructure. The two are no longer synonymous, with MLPs representing less than half of the sector. Investors seeking exposure to the infrastructure supporting American Energy Independence need to look beyond MLPs.

MLPs are valued as if the 30% in distribution cuts is gone forever, whereas in many cases CEOs have justified it as financing attractive projects. A commensurate increase in Free Cash Flow (FCF) over the next couple of years would provide some vindication of those decisions. The market is waiting to see evidence. We have calculated that 15% annual FCF growth across a broad swathe of energy infrastructure corporations and MLPs (as represented by the American Energy Independence Index) is likely. As evidence of that starts to show up, it should be the catalyst the sector needs to rebound.

The other important topic concerned opportunities to upgrade portfolios for investors who are already in energy infrastructure but unfortunately chose one of the tax-impaired funds. We wrote about this recently, in AMLP’s Tax Bondage. Although the title reflects our own shot at search engine optimization, the blog post highlights the tax drag that has led to AMLP performing at less than half its index. This might be the worst ever result for a passive ETF. It’s a regular subject for us, and recently Forbes published a splendid analysis of the burden faced by unwitting investors in such funds (see A Tax Guide to MLP Funds). Writer Bill Baldwin did some serious work to validate what we’ve been saying, and has performed a great service to investors in tax-burdened MLP funds everywhere.

The point of the tax discussion is to remind investors in the wrong type of energy infrastructure fund that this is a great time to sell (probably realizing a tax loss that might be a  useful offset against a FANG stock), so as to switch into a tax-efficient fund (which is the only kind we run).

In summary, pervasive energy infrastructure weakness awaits evidence that FCF growth is coming, and the timing is great for a portfolio upgrade by shedding tax-inefficient funds. This is the two-pronged message to investors and prospects in the sector. As conference attendees prepared to return to homes and spouses that are mostly located somewhere colder than Florida, the limited opportunity to get tanned was probably for the best.

August 2014 was the peak in the U.S. energy sector, as long time investors know too well. The Alerian MLP Index remains down by more than a third, and larger firms are increasingly abandoning the structure to become regular corporations (“C-corps”). The Shale Revolution has tested the old model of paying out 90% or more of cashflow. It worked when growth opportunities were limited, but nowadays every MLP has identified profitable areas in which to invest. Secondary offerings, how growth is financed, have found MLP investors to be unenthusiastic about reinvesting their dividends. This has in turn depressed MLPs as they’ve issued equity to unwilling buyers in order to finance their growth plans.  “Simplification” which generally involves conversion to a C-corp with adverse tax consequences for existing MLP equity holders, allows access to a far broader set of investors. The hope is that they’ll be more willing to finance the growth opportunities presented by the Shale Revolution.

Given the resurgence in U.S. hydrocarbon production in recent years, weakness in the sector that provides transportation, processing and storage was not inevitable. The famous “toll-model” of MLPs should have simply meant that more volumes meant more tolls. One might have expected the exploration and production companies to over-reach in their giddy search for more fossil fuels. There’s a good reason for the old saying, give an oilman a dollar and he’ll drill a well. We’d add, give a pipeline operator a dollar and he’ll build another pipeline. MLPs have often sought growth with irrational exuberance. Rising leverage, distribution cuts and broken promises followed. Many concluded that the MLP model was broken; in fact, the MLP model was fine but not suited to financing a growth business. Energy infrastructure used to be synonymous with MLPs, but so many have abandoned the structure that the Alerian MLP Index is no longer representative.

Canadian energy infrastructure companies have been run differently, and the chart above shows how the three largest firms (Enbridge, Pembina and TransCanada) have outperformed their U.S. peers. During the 2008 financial crisis, conservative management of Canadian banks generally helped them avoid the excesses that plagued some large U.S. ones. The same Scottish Presbyterian cultural roots appear to have similarly protected Canadian energy companies.

Canada doesn’t have MLPs, so Canadian energy infrastructure businesses are organized as conventional C-corps. Comparing the three Canadians with their U.S. U.S. C-corp peers, their leverage (Debt/EBITDA) is in line at around 4.9X. On an Enterprise Value/EBITDA (EV/EBITDA) basis, they’re slightly higher than the median U.S. C-corp at 13X versus 12X. And they’re expected to grow their dividends at around 10% this year.

The big difference is that the Canadians have achieved this without becoming over-leveraged, with the consequent cutting of dividends. Some U.S. MLPs converted to C-corps, in effect cutting payouts by merging with their C-corp GP. Others, such as Kinder Morgan three years ago, simply cut. Broadly speaking, Canadian management teams have behaved more conservatively and been more mindful of commitments made to their dividend-seeking investor base. With few exceptions, American managements have not.

The Shale Revolution has been a U.S. phenomenon; Canada has very little such activity, with its oil production centered on tar sands, a more expensive process that requires the same type of long-term capital commitments as the conventional oil business. But the North American pipeline network is highly integrated. Enbridge (ENB) demonstrated this by acquiring Spectra Energy two years ago, greatly increasing their U.S. network in the northeast. TransCanada (TRP) purchased Columbia Pipeline Group in an all cash deal, gaining a leading natural gas position in the rapidly growing Marcellus and Utica that links all the way down to the Gulf Coast. Not to be left out, Pembina (PBA) combined with Veresen, expanding their Bakken presence and gaining exposure to the U.S Rockies. So Canadian firms have been expanding their U.S. operations, but their greater financial discipline has enabled them to avoid imprudent growth. PBA in their most recent investor presentation on Slide 18 lists “Financial Guard Rails” which includes 80% of EBITDA from fee-based sources and maintaining an investment grade rating.

American management teams have been more risk-oriented in reaching for growth, and the results have largely fallen short of expectations. Last April, undaunted by not having $1.5B, NuStar Energy (NS) spent $1.5BN to acquire Navigator Energy’s Permian oil infrastructure network. In their 4Q17 earnings call management commented that Navigator’s EBITDA contribution was $14.5M for the quarter, yet they expect to spend another $240M building it out in 2018.  Hence the continued need for additional capital. Recently NuStar duly merged their General Partner with their MLP (simplified), which led to a distribution “reset” (cut). They sought growth over stability, and so far have achieved neither.

NS was simply one of the most recent in an ignominious history of American energy businesses that have failed to achieve what they promised. Kinder Morgan led the way in 2014, when they chose their growth plans over continuing stable distributions. Williams Companies (WMB), Plains All American (PAGP), Targa Resources (TRGP), Semgroup (SEMG) and Oneok (OKE) have all diverted cash from investors to new projects. Macquarie Infrastructure (MIC) remains the most brazen. As we noted in a recent blog post (Canadians Reward Their Energy Investors), when the company recently slashed its dividend after raising it the prior quarter, the CEO said it was necessary in order to pursue their growth agenda.

Warren Buffett was on CNBC the other morning, and when Becky Quick asked him if Berkshire would consider paying a dividend, he replied, “…dividends have the implied promise that you keep paying them forever and not decrease them..” U.S. energy infrastructure managers clearly feel differently.

Canadian energy infrastructure businesses have outperformed their U.S. peers because they’ve remained true to their original investors. They haven’t pursued imprudent growth, and they haven’t forgotten why their investors own their stock. MLP investors can no longer rely on a security’s yield because it’s become standard market practice to cut it either directly, or indirectly through a simplification. The older, wealthy Americans who were the quintessential long term MLP investor are gradually being replaced by institutions, because C-corps are an increasing portion of the energy infrastructure sector. Canadian firms are among the best managed, and so far they’ve been more adept at exploiting the Shale Revolution than U.S. firms.

This is why we created the American Energy Independence Index. By including Canadian companies and limiting MLPs to 20%, it’s more representative of U.S. energy infrastructure as well as conducive to being tracked by tax-efficient funds. The good news is that if American firms start being run like the Canadian ones, they could see a valuation uplift. The broad energy sector is out of favor, and given the positive tailwinds of growing North American oil and gas output there’s certainly plenty of upside. But the original MLP investors are unlikely to participate – they’ve been too badly let down. This remains the simplest and most plausible explanation for continued weakness. February was the worst month since January 2016, following which a strong rally ensued. Valuations, fundamentals and sentiment are sufficient to cause a repeat.

We are invested in ENB, KMI, NSH, OKE, PAGP, PBA,  SEMG, TRP and WMB

We thought it would be interesting to learn how the Shale Revolution has changed some of the midstream infrastructure businesses that support it. What have these companies learned, and how are their operations affected?

For the first in an occasional series on this topic, we chatted with Adrianne Griffin, Director, Investor Relations with Enlink Midstream (ENLK). Four years ago, ENLK was created when Devon Energy (DVN) combined its midstream infrastructure assets with those of Crosstex. Because DVN controls ENLK through its ownership of the General Partner (GP) Enlink Midstream, LLC (ENLC), the two businesses remain tightly linked. DVN can claim to own some of the original assets that led to the Shale Revolution; George Mitchell was an early pioneer of horizontal fracturing (“fracking”), and in 2001 DVN acquired its eponymous company which had unlocked natural gas reserves in the Barnett Shale, in north Texas. Without the Shale Revolution, it’s unlikely ENLK would have been created.

Like all energy infrastructure businesses, ENLK’s relies heavily on the activities of its oil and gas producing companies. Anticipating shifts in production is crucial to ensuring that pipeline and other capacity is available as needed. As the Shale Revolution has gained importance, companies like ENLK aim to align their capacity with customer demand. An under-utilized pipeline represents an inefficient use of assets, but no producer wants to find that output can’t be cheaply processed and transported. The alternatives are to move product by train or truck, both of which are more flexible but substantially more expensive and less safe.

Although the improvements in technology have largely been at the producer level, the resulting increased production certainly impacts the need for infrastructure. Ms Griffin discussed how multi-well pad drilling had dramatically boosted efficiency, since today it’s not uncommon to see a row of four pads with four rigs drill two dozen individual wells. She contrasted this with past practice of drillers poring over maps and selecting single well locations with a marked dot. Today, it’s increasingly common to see software engineers remotely guiding multiple drilling rigs from a central control station (see Drillers turn to big data in the hunt for more, cheaper oil).

Although the Barnett Shale was where the Shale Revolution began,  it was long eclipsed by prolific gas output from the Marcellus in the northeast and oil production in the Permian Basin in west Texas. Oklahoma’s “Scoop and Stack” is another high-producing region, and ENLK is well positioned to benefit from increasing production there. Techniques originally developed in Mitchell Energy’s original acreage have been successfully transferred from north Texas to Oklahoma. Although ENLK is slowly diversifying its customer basis, it’s no surprise that DVN is 50% of their business in that region.

Pressure is the name of the game. Ms. Griffin explained why “Keep the pressure low” is a constant refrain. If the pressure at which existing oil and gas are moved through the pipeline network is too high, it makes it harder for new production to enter the system. A key element of managing flow is to find the right balance between optimal management of the pipeline network that still accommodates additional supply coming on. Shale wells are characterized by high initial production rates that decline quickly. When you combine this with multi-well pad drilling, it can lead to producers quickly adding new supply that soon tapers off. In order to manage overall pipeline pressure, drillers often leave some wells as Drilled Uncompleted (“DUCs”), or choke back initial output, in order to deliver less variable flow to their midstream infrastructure provider. Drillers and their infrastructure providers are in constant contact.

On the processing side, ENLK have been investing in new, cryogenic processing plants, because the gas stream they’re asked to process is a lot “richer”. This means it contains Natural Gas Liquids such as ethane and propane, which must first be removed and sold separately before the methane can be supplied to customers as natural gas.

In an interesting twist, DVN recently announced plans to divest its acreage in the Barnett to focus on Oklahoma and West Texas.   However, technology has improved tremendously since George Mitchell’s day, and it’s allowing the re-exploitation (‘re-frack”) of wells that were previously regarded as having little remaining commercial value for new potential owners.

Since ENLK is an MLP with a GP, no discussion would be complete without asking about the financing model. Over the past couple of years most large MLPs have combined their GP and MLP. Euphemistically called “simplification”, it’s generally resulted in lower distributions and unwelcome tax consequences for investors. Although management teams typically blame the difficulty of raising equity capital with the GP/MLP structure, the problems are invariably self-inflicted as overly ambitious growth plans stretch distribution coverage and leverage covenants. NuStar’s recent combination with its GP, NuStar GP Holdings, is an example.

While ENLK has certainly benefited from a strong corporate sponsor in DVN, they’ve also maintained leverage at 3.5-4X Debt:EBITDA, and have managed their growth so as to retain an investment grade debt rating. More than three years since the peak in the energy infrastructure sector, it’s a prudent approach that is paying off.

We are invested in ENLC

Although we’re used to reading about growth in U.S. shale production, recent figures from the Energy Information Administration are still striking. Crude oil output from the Permian in west Texas is set to reach 3 Million Barrels per Day (MMB/D) in March, up by more than 70K from February. Output is growing at an increasing rate. Natural gas output is also growing – Appalachia (how the EIA refers to the Marcellus Shale in Pennsylvania, Ohio and West Virginia) is expected to produce around 27 Billion Cubic feet per Day (BCF/D) in March. The Permian represents close to a third of all U.S. crude output, and the Marcellus just over a third of natural gas.

In December, the EIA forecast Permian growth of 515K in daily output over 18 months from June 2017 to the end of this year, so the March 2018 increase is almost three months’ worth. The International Energy Agency is similarly optimistic, predicting that the U.S. will be the world’s largest oil producer by 2019. This seems like good news if you’re American and especially if you’re employed or invested in the energy sector. But the cloud on the horizon is whether this presages a repeat of the 2014-16 oil price collapse that was caused by surprisingly fast U.S. output. The WSJ noted that U.S. crude output looks set to outpace global demand in 2018, rekindling unpleasant memories. One observer tweeted “US shale firms remove pistol, aim at own foot, and fire.” However, crude prices barely dipped on the news.

U.S. oil and gas producers promise greater financial discipline following vocal investor feedback. Achieving an acceptable return on capital is now more fashionable than growing production. Chevron, Anadarko and ConocoPhilips have all recently announced dividend hikes, thoughtfully providing investors with a little Valentine’s Day love.

The bullish case for energy infrastructure rests on sustainable production growth, so although pipeline owners don’t drill for crude oil the financial health of their customers is important. Although U.S. output growth may exceed net new demand, existing oil fields experience aggregate global depletion of 3-4MMB/D, so new supply needs to cover this as well. In spite of the Shale Revolution, there’s still a need for other new sources of supply. If U.S. producers are sincere about their financial discipline, this should lead to more sustainable growth in output and good business for energy infrastructure.