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.

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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

FERC’s ruling earlier today disallowing income tax recovery on interstate pipeline contracts is roiling the sector and we continue to analyze the likely impact. We believe it should only affect pipelines owned by MLPs not corporations. In our funds we maintain MLP exposure at below 25%. This ruling may disadvantage MLPs versus corporate owners, and MLP-only funds are clearly most exposed.  This has been an issue for many years and we expect the MLP industry to appeal.

Within the MLPs we own, there are many reasons to expect a limited impact. This does not affect gathering, processing, storage, export, LNG, fractionation or intrastate assets.  Furthermore, many interstate contracts are negotiated based on market based rates instead of subject to FERC rates and others have pre-agreed upon terms for adjustments. For example, Energy Transfer Partners’ (ETP) assets include intrastate (as distinct from not interstate) pipelines in Texas, which are not affected by FERC’s decision today. In other cases, such as ETP’s Dakota Access, there seem to be few good alternatives for shippers as there is still insufficient takeaway capacity from the region with some use of crude by rail. Williams Companies (WMB) Transco pipeline network still looks to us like the cheapest way to move natural gas out of the Marcellus. Although MLP Williams Partners (WPZ) owns Transco, they could theoretically combine with parent WMB and house the assets in a corporation.

It’s possible this could be another justification to shift energy infrastructure ownership from MLPs to corporations, which is where we are mostly invested. We are not currently making any portfolio changes.

We are invested in Energy Transfer Equity (ETE, General Partner of ETP), and WMB

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.

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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.

It’s surprisingly difficult to find out what MLP distributions have been doing. Alerian claims that their index has been growing its payouts at a 6% average annual rate for 10 years, with growth continuing in 2016 (it’s not yet updated for 2017). However, their methodology is odd. They take the trailing growth rate of the current index constituents, which are regularly updated. This tends to bias the growth rate up, because they dump poor performers and add good ones. We examined this in a recent blog (see MLP Distributions Through the Looking Glass).

Because Alerian doesn’t publish the actual experience of its index investors, it’s necessary to look at how investment products tied to those indices have done. Not surprisingly, payouts have fallen. As the chart shows, for the JPMorgan MLP ETN (AMJ) and for the Alerian MLP Fund (AMLP), two of the largest vehicles in the sector, dividends are down approximately 30% from their highs in 2014-15. This is what MLP distributions have been actually doing – falling, not rising — in spite of what is sometimes implied. Perhaps coincidentally, the cut in payouts is similar to the drop in the sector (38%) from its August 2014 highs.

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As we’ve written before, the Shale Revolution induced many MLP managers to pursue growth opportunities (see More on the Changing MLP Investor). The need for growth capital pressured financial models that historically distributed 90% of Distributable Cash Flow (DCF), when growth needs were minimal. Leverage rose, growth projects were favored over reliable payouts, and distributions were cut. Investors felt let down if not deceived.

Although the big picture is simple, at each company level there are more detailed reasons why growth plans that were not expected to threaten payouts nonetheless led to cuts. Plains All American (PAGP) saw its Supply and Logistics business drop from $900MM in EBITDA to less than $100MM over two years. Kinder Morgan (KMI) was hurt by the cyclicality of its Enhanced Oil Recovery business. But broadly speaking, the dividend cuts were a redirection of cashflows into new projects, rather than reflective of poor operating results.

Over the next couple of years we’ll see if that redirection of cash pays off. The Miller-Modigliani model of corporate finance holds that investors should be indifferent to a company’s capital structure, and should not value dividends (since anybody can create a 5% dividend by selling 5% of her shares annually). Although financial markets don’t always operate that way, the question hanging over the industry is whether these redirected cashflows will eventually deliver their pay-off. If the foregone dividends have been wisely invested, DCF should grow.

We’ve looked at this for the components of the American Energy Independence Index. It consists of 80% corporations and only 20% MLPs. Since many MLPs have converted to C-corp status, energy infrastructure is leaving MLPs with a diminished status. It includes some Canadian companies, since they also operate U.S.-based infrastructure assets and, as we’ve noted, have been rather better run of late than their American peers (see Send in the Canadians!).

Using company data and estimates from JPMorgan, we calculate a two year compound annual growth rate of DCF for this group of businesses of 15%, from 2017 to 2019. Some of these companies were in the Alerian index but left as they became C-corps, some were never in, and some still are. A perfect match is impossible because the constituents of the Alerian MLP index have changed over the years. But that 15% growth rate will significantly support the correctness of those decisions to redirect cashflows from payouts to new opportunities. It won’t be true in every case, and to be sure many investors would have preferred it didn’t happen. But it will provide a form of vindication for managements that increased investment back into their businesses.

The sector has been priced as if the distribution cuts were fully reflective of weaker operating results, whereas in most cases they’ve been to support future growth. Investors appear to be assuming away the foregone distributions, as if the operating cashflows supporting them have disappeared, whereas many companies have been financing growth plans with this internally generated cash.  MLP investors are likely not passionate about Miller-Modigliani, but we’ll see in the months ahead whether the theory has worked.

We are invested in KMI and PAGP

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.

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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

On Thursday Energy Transfer Partners (ETP) released earnings that beat expectations on just about every measure. Midstream infrastructure businesses generally don’t report results too far from consensus – surprises usually come in other ways (more on this below). ETP’s $1.94BN of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) was more than 10% ahead of Street estimates. NGL/Products, Midstream, Natural Gas and Crude Oil segments all delivered impressive results.

ETP’s yield has remained frustratingly high for investors and management. At 12%, it reflects substantial investor skepticism about the prospects of its continuation. CEO Kelcy Warren might have felt that Thursday’s results would cause a sharp revaluation higher, whereas ETP managed a muted 4% gain. Its yield remains stubbornly high.

Earlier in the week Warren had testified in Delaware at a civil class action suit against ETP’s General Partner, Energy Transfer Equity (ETE). The plaintiffs contend that a 2016 issuance of convertible preferred securities to 31% of unitholders (ETE senior management) represented an impermissible transfer of value away from investors. We have written about this before (see Will Energy Transfer Act With Integrity?) The offending securities were issued at a time of severe weakness in ETP and ETE stock prices due to the ultimately failed effort to merge with Williams Companies (WMB).

In short, the securities allowed management to reinvest their future dividends at the then current low price, but further protected them from future dividend cuts. A rising stock price would see them reinvesting at an historic, lower level, and if the price fell due to a dividend cut their special dividends would be partially protected.

It looked like an aggressive ploy to force WMB to cancel the deal, since the result was to dilute the value of the merger to WMB investors. But even after the deal collapsed for other reasons (a revised tax opinion that conveniently rendered it unworkable), the new securities remained.  Kelcy’s ill-advised pursuit of WMB justified issuing special securities with the stock price at its low, and he wanted to keep them.

Investors sued ETE, quite rightly claiming self-dealing by management. Judge Glasscock will soon decide the legal outcome. However, the market has already offered its opinion. Energy Transfer is a well-run business that will provide management a sweetheart deal given the chance. Strong operating results from attractive assets receive a valuation discount because of sly management. As we said once before, investing with ETE is like sitting at a high-stakes poker table with a strong hand drawn from a deck of marked cards. Energy Transfer’s securities are valued accordingly.

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Last week Macquarie Infrastructure Corporation (MIC) showed why investing for the long term requires a management team that shares this vision.

In a move that stunned investors, MIC announced weak operating results, lower guidance and a dividend cut. MIC’s infrastructure businesses are not limited to energy, since they have an aviation division too. But they are included in some energy infrastructure indices as well as held by investors who focus on the sector. They just showed why market sentiment towards such businesses remains so poor.

As recently as November, MIC announced a 10% dividend hike, forecasting 2018 growth in Free Cash Flow (FCF) of 10-15%. Just three months later, they cut the dividend by 31% and lowered their FCF growth forecast. It’s true there had been a change in CEO in the interim, but investors had little reason to expect this type of outcome.

The subsequent conference call showcased why so many investors have lost faith in infrastructure businesses. When asked to justify the dividend cut so soon after raising it, CEO Christopher Frost commented, “Could we have taken a different path?…Yes…But maintaining our dividend policy would likely have meant…forgoing our growth agenda” (emphasis added).

This is exactly what has alienated investors and caused new buyers to pause. MIC invited a set of equity holders that valued growing dividends. They then chose to repurpose those cashflows to invest in new projects, even though they haven’t recently demonstrated much ability to estimate returns on investment. So what type of investor should hold MIC? A fairly fleet-footed one.

A management team that doesn’t have a consistent long term outlook will draw investors who don’t care about the long term view. MIC was understandably down 38% on the day. It’s unclear what anybody should expect from the company.

Too many American energy infrastructure businesses have let investors down. Often they’ve chosen growth over what their existing financiers want, and sometimes they’ve ignored their fiduciary obligation, shredding expectations and losing support. Valuations are attractive in part because of management teams that continue to alienate investors.

It doesn’t have to be so. Canada’s Pembina Pipeline Corporation (PBA) also announced good results last week. They have no history of issuing special management-only securities. They generally do what they tell you. They describe their financial model as based on “guardrails” with metrics oriented towards 8-10% FCF growth while maintaining their investment grade credit rating. On their conference call they said acquisitions were low on their list of priorities, behind operating existing assets more efficiently and building from scratch. Investors rejoiced, driving their dividend yield down to 5.25% as the stock rose. The Canadians seem to be getting it right.

We are invested in ETE and PBA

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

On Thursday the U.S. Energy Information Administration (EIA) released updated figures on proved reserves as of 2016. In order to count as proved, companies must be reasonably certain that the reserves are recoverable under existing operating and economic conditions. Improvements in technology have increased the amount of recoverable reserves from some shale formations.

The dramatic increase in Permian reserves is driving increased production. As we noted (see Rising Oil Output Is Different This Time), Permian output is set to reach 3 Million Barrels per Day (MMB/D) in March. It’s increasingly looking as if pipeline demand is approaching capacity. JPMorgan recently said they expect pipeline bottlenecks to develop in 2H18 and into 2019, before additional capacity currently under construction is added. But they expect that by 2020 tightness will occur again. Permian production is expected to reach 3.5 MMB/D by the end of this year, and continue rising to 4.1 MMB/D through 2019 and 4.9MMB/D by 2020.

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New takeaway capacity will be required by then. In recent years, midstream infrastructure businesses have rarely missed an expansion opportunity even if it led to stretched balance sheets. NuStar (NS) was the most recent firm to acknowledge such over-reach. The collapse of their GP/MLP structure and distribution cut announced ten days ago were caused in part by the failure of their early 2017 Navigator acquisition to ramp up cashflows quickly enough. The industry’s history of providing new capacity too readily has diverted cashflows from distributions to growth and debt repayment, frustrating traditional investors. They’ll be hoping that recent financial discipline sweeping across energy producers similarly afflicts pipeline operators, resulting in higher returns on future projects.

Overall U.S. proved reserves of crude oil and lease condensate were virtually unchanged in 2016 versus 2015 at 35.2 Billion Barrels. Gains in the Lower 48 states were offset by declines in Alaska and offshore. Proved reserves of natural gas rose 5% to 324 Trillion Cubic Feet, as total additions were 150% of production. The U.S. continues to enjoy a substantial cost advantage in natural gas production, with exports of Liquified Natural Gas (LNG) set to reach 10 Billion Cubic Feet per Day (BCF/D) by late 2019, 3% of global consumption.

Commodity prices affect proved reserves as they have to be commercially recoverable. The 2016 oil and gas prices used for these calculations were 15% and 6% lower than in 2015. When the 2017 figures are published they’ll be based on oil and gas prices 20-21% higher. U.S. reserves are likely to keep growing.

The American Energy Independence Index (AEITR) finished the week +2.7%.

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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.

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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.

Risk Parity is a portfolio construction technique that seeks to allocate capital so as to maintain similar levels of risk from each asset. Some commentators are blaming it for the recent market turmoil, since superficially its practitioners are expected to reduce risk when it rises. That can often mean selling stocks. AQR is among the asset managers who employ this approach. In 2010 they published a paper explaining the theory, noting that traditional portfolios typically derive a larger proportion of their risk from equities than is implied by simply looking at percentage allocations.

A 60:40 stocks/bonds portfolio will incur more than 60% of its risk from stocks, because they move more than bonds. Risk Parity seeks to compensate for this, and the paper showed improved returns over a passive 60:40 approach. The paper goes on to describe a portfolio with less equity exposure than a traditional 60:40 portfolio and correspondingly less risk. Because it has a higher Sharpe Ratio (i.e. better risk/return) but lower return, leverage is then employed to raise the risk to the same as 60:40, at which point the return should be higher.

Since allocations under a Risk Parity regime target a given level of risk, changes in risk estimates will lead to a shift in allocations, and may also require changes to leverage. One popular measure of risk is volatility. For simplicity, we’ve defined it as the average percentage daily move over the prior ten days. Although Risk Parity is typically applied to asset classes, the concept can also be applied to sectors within an asset class. A strategy of achieving Risk Parity among asset classes can also be designed to achieve Risk Parity across sectors within an asset class.

In response to criticism that funds employing Risk Parity are behind the recent sharp moves, some managers of such funds have responded that such shifts are slow – their models are designed to recalibrate over longer periods than just a few days. It’s impossible to know the extent to which the critics are right — on Friday JPMorgan estimated that most of the “severe” unwind was over. However, we’ve noticed another shift, which is that risk in the energy sector is falling relative to the S&P500. This is partly due to correlations increasing, as they do during market dislocations. Sector differentiation becomes less important than overall market exposure, and sectors move up and down together. For example, the S&P Low Volatility Index is down 6.5% for the month, almost as much as the S&P500 itself (down 7.2%), even though Low Vol should be, well, less volatile.

Nonetheless, Risk Parity strategies that are deployed at the sector level could eventually increase energy exposure at the expense of other sectors whose relative volatility against the S&P500 has increased.

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It can seem an arcane topic. But put simply, in a time of heightened volatility, the Energy sector is gyrating with the rest of the market whereas it was previously moving sometimes twice as much. The first chart compares XLE with SPY, where although average daily moves have increased in both cases, SPY moves have jumped by 150% while XLE moves have “only” doubled.

Many reliable trends have abruptly shifted, including persistent low volatility. The spectacular collapse of the Credit Suisse note (XIV) following the spike in volatility was extraordinary. Why would people hold a product that seems destined to eventually blow up?

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The difference in volatility is more dramatic when comparing Energy Infrastructure (defined here by the American Energy Independence Index) with the S&P500. Their average daily moves are roughly the same. Until recently, energy infrastructure (including MLPs) was moving twice as much as the broader market. Domestic, midstream assets that support U.S. energy independence have experienced a comparatively modest increase in volatility compared to the overall market. Daily moves in the S&P500 and energy infrastructure are converging. At a time of increased uncertainty, if investors begin to value the more reliable cashflows these companies generate, further buying of the sector will follow.

The American Energy Independence Index (AEITR) finished the week -4.2%, outperforming the S&P500 which was -5.2%.