Long time subscribers will recall that back in 2015 this blog sought ever more creative and different ways to communicate the same message, which was that MLP prices had fallen far enough and represented compelling value. Bear markets have an unfortunate tendency to last longer than their opponents would like. Although the sector rebounded strongly in 2016, some of those 2015 blog posts were premature.

One lesson is that if you’re going to write constructively during a bear market, marshall your arguments and prepare to spread them over more weeks than you might anticipate. Last week MLPs and crude oil rediscovered their once close relationship, to the detriment of investors in energy infrastructure. Forewarned, your blogger will not expend all his constructive thoughts right away.

Prior to the Shale Revolution, MLPs were fairly described as having little correlation with commodity prices. Pipelines were a toll-like business model whose returns were driven by volumes. Today, much of the point of investing in the sector relies on the growth prospects made possible by the Shale Revolution. Ten years ago the need for new investment was limited; today it’s clear that to exploit newly accessible hydrocarbons, infrastructure needs to support these new locations. North Dakota was not known for oil, nor was Pennsylvania known for natural gas.

Therefore, the returns on energy infrastructure investments are nowadays more sensitive to growing domestic production and the consequent utilization of existing as well as planned infrastructure. To take one example, Plains GP Holdings (PAGP) anticipates a substantial increase in EBITDA if growing oil production absorbs more of its available pipeline capacity. Oil production reacts to prices; PAGP’s prospects are linked to those of its customers.

Last November’s strategy shift by OPEC to cut production was an ignominious admission that their prior effort to bankrupt the U.S. shale industry through low prices had failed. It represented a watershed event, the moment when it became clear that a new paradigm was in place, as we noted in The Changing Face of Oil Supply.

“Short-cycle opportunities” are what every oil company needs. Shale now counts the biggest integrated oil companies among its proponents. Exxon (XOM) CEO Darren Woods recently noted that a third of their capex budget is devoted to such opportunities. The key here is the liquidity of the oil futures market. If your project’s timeframe extends beyond the availability of hedge instruments, your IRR is going to be driven by things you can estimate but not control. The real revolution of shale is its short capital cycle; numerous wells are drilled cheaply, with fast but sharply declining production. Capital invested is returned with a year or two and risk can be hedged. Conventional projects require huge upfront commitments with long payback times and consequently uncertain economics.

The recent sharp drop in oil prices hasn’t been pleasant for producers anywhere. But consider the planners of a conventional project – a Final Investment Decision to proceed is a little less certain. Once capital is committed beyond a certain point, there’s little choice but to press on and accept whatever outcome markets deliver. Whereas shale producers, the group whose success ostensibly caused the 2015 crash, can cut back activity with comparative ease. They can just stop drilling, and wait. They can take advantage of even brief rallies in crude futures to hedge production and increase output.

This is why capex on conventional projects continues to fall, as shown in the attached chart from a recent presentation by Lars Eirik Nicolaisen of Rystad Energy. The longer term problem is shaping up to be insufficient investment in new supply to offset depletion of existing fields and new demand (estimated to require around 6% of new supply annually, about 6MMBD, or Millions of Barrels a Day).

The recent drop in crude demonstrates no shortage of supply currently, but also makes providing new supply less attractive in the long run.

MLP investors easily recall the 50.8% drop in the Alerian Index from August 2014-February 2016, its low coinciding to the day with that for oil. We don’t know where crude prices will go over the short term, but it’s becoming increasingly clear that the U.S. is set to gain market share because its short-cycle opportunities represent a substantially more attractive risk/return than conventional projects.

Reaching the long term requires navigating the short term. While you’re doing that, consider how you’d seek your company’s Board approval for a conventional oil project requiring ten years of output to recover its upfront cost. Those shale guys in the Permian could wreck your assumptions, and then protect themselves from the damage they’d wrought by quickly cutting their own capex and production. Without an adequate response, you might feel like moving to West Texas.

We are invested in PAGP

A few weeks ago I did an interview with friend Barry Ritholtz for his Bloomberg series “Masters in Business”. It was just posted online, so for those that are interested you can find it here. Comments on MLPs are at the 65 minutes mark.

There’s a developing paradigm shift under way in the oil market. It is manifesting itself through the quarterly earnings reports of many energy sector companies. At a high level, discoveries of new oil and gas fields recently fell to a 60-year low. Last year there were 174 oil and gas discoveries, compared with 400-500 a year until 2013. 8.2BN barrels equivalent of oil and gas were found, a fifth of the equivalent figure in 2010 and a level last seen in the 1950s.

Capex budgets for conventional exploration have been slashed. Chevron (CVX) cut their $3BN 2015 budget to $1BN last year. ConocoPhillips (COP) is pulling out of new deepwater projects altogether. Baker Hughes (BHI), who provide services to the industry, saw weakness in their non-U.S. business that was partially offset by strength in the U.S.

But not everyone is cutting back. Marathon Oil (MPC) is doubling its investment in new shale projects. Continental Resources (CLR) is spending $1.7BN which they expect will drive 20% annual growth in oil and gas output through 2020. Devon Energy (DVN) is planning to add rigs in the Barnett Shale where they’ll exploit advances in technology to “refrac” previously drilled wells. On DVN’s recent earnings call, CEO David Hager described their plans to use modern drilling and completion technology in areas that had previously exhausted their commercially viable output.

These companies and others like them are the customers of the energy infrastructure businesses that we own. For example, Enlink Midstream Partners (ENLK) is the direct beneficiary of DVN’s activity because their increased output will flow through ENLK’s infrastructure. It doesn’t hurt that ENLK’s General partner, Enlink Midstream LLC (ENLC), is owned by DVN. So we follow the plans of domestic Exploration and Production (E&P) companies even though we’re not directly invested in them.

The crude oil market (and to a lesser extent natural gas),  is shifting in ways that are incredibly favorable to  the U.S. The key lies in the differences between shale and conventional production.

The reasons are in the table above, and were described in America Is Great! Conventional oil projects take a long time to implement and earn back their capital investment. Shale projects are the opposite. To understand how the U.S. is the big winner, consider how you would evaluate a conventional oil project costing, say, $1BN up front with a ten year payback period that is profitable only with oil above $50.

Once you commit, you can only hedge your crude exposure out for two or three years. You can analyze the oil market and arrive at reasonable price projections, but it was at $26 a barrel a year ago. So it might get there again. Shale technology keeps improving, so you have to assume that breakeven costs for shale output will continue to fall. It was shale output that caused the last crash. In approving the $1BN investment you have to make a judgment on the probability of a ruinously low oil price making your project unprofitable. And you can’t hedge this risk.

People often ask me what is the breakeven for U.S. shale production. There is no specific number, it varies from less than $20 per barrel in some places to well over $100. The production that is profitable takes place, and the unprofitable doesn’t. Profitability isn’t binary, with the industry all making profits above $X per barrel and losing money below. Costs can be substantially different even within the same play. It’s not a homogeneous industry. It’s more accurate to think of a finely graduated supply curve that increases output by 25-50K barrels a day for each $1 increase in price. Their short response time allows shale producers to drill and complete additional  wells within months in response to improved economics.

Over the next ten years crude oil might stay above the $50 breakeven in the hypothetical project described above, and yet the project never get done because the risk of a price collapse was ever-present, hanging over the project’s IRR like the sword of Damocles. In this way, supply that could have been produced commercially will not come to market, allowing the nimble producer with a short response time to benefit from prices higher than they might have been otherwise. Because shale producers don’t face the same magnitude of price risk, they are in a far stronger position. Last week, the U.S. exported 1 MMB/D of crude oil. BP CEO Bob Dudley recently said that U.S. shale production will keep a check on any spikes in oil prices.

Price cycles in crude oil should be milder in the future, because the market has a shorter response time for new supply. Costs will continue to fall for “tight” oil and gas. America’s energy business has extraordinarily strong prospects.

We are invested in ENLC

The early part of 2017 has been kind to MLP investors. The generally reliable year-end effect has seen prices rise (see Give Your Loved One an MLP This Holiday Season). President Trump’s unabashedly supportive stance towards energy infrastructure has certainly helped sentiment, as have a number of corporate finance moves. The Alerian Index is up almost 8% so far this year (through Friday, February 3rd),  as investors have acted on the positive news. MLP CEOs are Trump fans because they see lots of positives for their industry in his policies.

But behind the scenes, some of the C-corps whose General Partners (GPs) control their MLP are reassessing the GP/MLP financing model. In 2014 Kinder Morgan led the way by consolidating their structure. The MLP is a good place to hold eligible assets; the absence of a corporate tax liability (because MLPs are pass-through vehicles) lowers their cost of equity capital. Countless corporations over the years have “dropped down” energy infrastructure assets into an affiliated MLP in order to take advantage of this. However, the Shale Revolution has ironically challenged this model.

This is because the universe of MLP investors is limited to U.S. taxable investors. In practice, it’s further limited to high net worth (HNW) investors because the dreaded K-1s provided by MLPs (rather than 1099s as is the case with regular corporations) are only really acceptable to people who have an accountant prepare their tax return. Tax-exempt and non-U.S. investors face formidable tax barriers which largely eliminate their interest. Although investors in U.S. equities are mostly institutions from around the world, these considerations mean MLPs are mostly held by U.S. taxable, HNW, K-1 tolerant investors. This group is a small subset of the universe of global equity investors.

The Shale Revolution has created a need for substantial investments in America’s energy infrastructure (see the chart America’s Infrastructure – More Growth to Come in America Is Great!). Traditional MLP investors (U.S. taxable, HNW, K-1 tolerant) are not willing or able to provide the financing needed. This most obviously manifested itself in 2015 when MLP prices crashed under the weight of the need for growth capital (see The 2015 MLP Crash; Why and What’s Next). Kinder Morgan to some degree anticipated this when they simplified their structure. By moving their assets from Kinder Morgan Partners (KMP) to Kinder Morgan Inc. (KMI), they vastly increased their potential investor base.

In the process KMI took advantage of tax rules that allowed them to create a substantial tax shield. When they bought the assets from KMP, their value was stepped up from carrying value to current market. Normally, if Company A buys Company B for $100 and Company B’s book value is $60, the $40 premium to book value sits on Company A’s balance sheet as Goodwill. This is a balancing item, since you can’t spend or depreciate Goodwill. However, KMI showed that when buying a partnership (or more precisely, the assets held by the partnership), those assets are in effect revalued at $100 (using our prior example). There’s no Goodwill, simply assets whose carrying value is now their current market value. In the case of KMI, depreciation was then calculated from this higher level, allowing KMI to offset its taxable income with depreciation charges totaling $20BN over many years. The flip side of this was that KMP investors wound up with an unexpected tax bill. KMP was widely held by MLP investors, and this unwelcome tax surprise has left many with a bitter taste ever since. For more on this, see The Tax Story Behind Kinder Morgan’s Big Transaction.

Oneok (OKE) basically did the same thing last week when they bought up the units of Oneok Partners (OKS) that they didn’t already own, thus consolidating into a single entity. OKE has an estimated $14BN tax shield, helping to fuel faster growth since they’re not paying taxes for a few years. OKS investors will get an unwelcome tax bill just as was the case with KMP. It’s not a terrible transaction other than the pricing. Once again, the advice provided by their investment bank was poor. In fact, I’m reminded of Ronald Reagan’s quip that the nine most terrifying words in the English language are, “I’m from the government and I’m here to help.” If Reagan was an MLP investor today, he would update his warning to be, “I’m from Wall Street, and I’m here to help.”

MLPs have been the victims of so much bad advice lately from highly paid investment bankers that it’s hard to remember any actions that were the result of good advice. Most recently, OKE somehow convinced themselves that a 23% premium to the prior day’s close was an appropriate price at which to buy OKS units, even though they already owned 40% and controlled the entity. In this case, JPMorgan Securities and Morgan Stanley are the banks whose advice destroyed value for OKE. A premium of 5-10% would have been more than sufficient reward to OKS holders. They would have shared in the $14BN tax shield anyway through swapping their OKS units for shares in OKE. A big premium wasn’t necessary. Morgan Stanley investment bankers are active purveyors of wrongheadedness – only a few weeks ago their advice to Williams Companies (WMB) led to a sharp drop in their stock price when it emerged they’d given up their Incentive Distribution Rights (IDRs) too cheaply (see Williams Loses Its Way). WMB raised $1.9BN in equity which was then funneled to Williams Partners (WPZ), illustrating that they regard the C-corp as the better way to access investors but in the process weighing down the peer group of C-corps.

Putting aside the cost of lousy investment bankers, the theme behind these and other moves is that U.S. energy infrastructure has tremendous growth ahead of it. OKE and WMB are positioning themselves to be able to finance this growth in the most efficient way possible. They may in time need more financing than traditional MLP investors will provide. Other recent transactions, such as Plains All American’s (PAGP) $1.2BN investment in a Permian Basin gathering system, or Targa Resources Corp’s (TRGP) secondary offering to finance up to a $1.5BN investment (also in Permian gathering assets) similarly reflect growth opportunities. The market was non-plussed with both of these, in part because they involve new sales of stock by each company. But there are increasing signs that Permian crude oil output will challenge the existing take-away capacity from the region, improving the pricing power for those pipelines already in place.

In total, all this activity has been good for MLPs, thanks in part to Wall Street bankers guiding their pliant clients to overly-generous deal terms. Somewhat for the same reason, it has been less good for the C-corps that control these and other MLPs. However, the driver behind all this activity is the road that takes America to Energy Independence. Energy infrastructure managements are reconsidering the structure and making new investments precisely because of the growth opportunities they see. Through all this there is a certain life-cycle to the GP/MLP. Since it’s hard to do better than hold assets in a non-tax paying entity, the MLP is hard to beat:

1. Energy corporation “drops down” assets to MLP it controls through its GP stake. GP earns IDRs, creating Hedge Fund Manager/Hedge Fund type relationship
2. Combined enterprise grows and reaches point where IDR payments to GP start to drag on MLP cost of equity capital, and need for equity financing demands access to global equity investor base
3. Corporation buys back MLP, acquiring assets whose carrying value has been depreciated down far below market. Resetting the assets allows depreciation from this higher level, eliminating tax obligation for some years which fuels faster cashflow growth while saddling MLP investors with unwelcome tax bill.
4. As assets are depreciated down, holding assets in the corporation becomes less efficient as they start owing taxes again. Creating an MLP (Version 2) becomes increasingly attractive.
5. Return to #1

The largest energy infrastructure businesses are concluding that they need to be a corporation. If the balance sheet value of their assets is high enough the resulting depreciation charge can, for a time, offset their taxable income. A non-tax paying C-corp can be preferable to an MLP, because you can access more investors. But in time the depreciation charge loses its ability to offset taxable income. At that time you might see some of these companies create MLPs again, repeating the cycle.

The GP/MLP structure remains attractive for a great many businesses whose enterprise value is below the $30BN or so level at which size seems to become an issue. And because of the tax shield, the bigger firms are finding ways to hold infrastructure assets with many of the advantages of an MLP. Whether held in a C-corp or MLP, America’s energy infrastructure is largely exempt from paying corporate taxes, allowing more of the returns to flow to the owners.

Recently in A Few Thoughts on Long Term Energy Use we included the striking chart shown again below comparing CO2 emissions from power generation in the U.S. and Germany. It elicited quite a few comments from readers because it showed that Germany is now lagging behind the U.S. on this metric. Germany has set out to be a global leader in the use of renewables. By 2050 they aim to generate 80% of their electricity from renewables and to cut their greenhouse gas emissions by up to 95%. Until 2015, Germany had the world’s largest installed solar capacity, which reflects quite a commitment because there are plenty of sunnier places on the planet than northern Europe. The push to renewables (dubbed “Energiewende”, or Energy Transition, in German) enjoys widespread public support, which extends as far as surcharges on household electricity. German consumers pay among the highest prices for electricity in the world, largely due to taxes and other charges in support of renewables.

By contrast, the U.S. has a more ambivalent view. Strong opinions are not hard to find on both sides of the debate over whether global warming is man-made. Some states, notably California, have implemented policies to reduce emissions as they became frustrated with inaction by the U.S. Congress. President Obama sought to impose stricter regulation on emissions through executive actions, but President Trump has said the U.S. will withdraw from the Paris Agreement on Climate Change. American public opinion doesn’t reflect the same concern about the issue as Germany. And yet, measured by CO2 output per unit of electricity, we’re doing better. Lower U.S. emissions come with cheaper electricity which stimulates economic growth.

The Shale revolution is certainly part of the reason. Abundant, cheap, clean-burning natural gas has been steadily replacing dirtier coal as the fuel of choice for power plants. In October (the most recent figures available) 33% of U.S. electricity produced came from natural gas, about 1% ahead of coal. Renewables were 15%, of which hydroelectric is just over a third. The rivers and waterfalls whose flows can be harnessed have long been identified, so don’t expect hydro to grow much. Solar and wind were 7.5%, up from 5.9% a year ago. Germany’s solar and wind contributed 18.2% of their power generation, although by consumption it was less because they export some of this clean electricity (see below).

Germany’s Energiewende faces two problems. The first is common to solar and wind everywhere – it’s not always sunny and windy. Since it’s still not currently possible to store large amounts of electricity cheaply for later use, conventionally powered baseload electricity capacity is required. Germany’s shutting down many of their nuclear reactors following Japan’s 2011 Fukushima disaster increased their reliance on coal to ensure a certain minimum amount of electricity is available. Around 12% of Germany’s electricity is generated by natural gas, and while it might make sense to increase this, Russia is their biggest supplier. Greater reliance on Russia’s Gazprom would synchronize disruptive pipeline maintenance with periods of policy disagreement between the two countries.

Their second problem is that wind power comes from the northern part of the country and Baltic Sea, while it’s needed in the south. Today’s north-south transmission capability is inadequate to move what’s generated.

A further unexpected consequence of the move to renewables has been distortions in Germany’s electricity market. At times the operators of windfarms have been paid to stop electricity generation since the spot price has gone negative. At other times Germany has exported cheap electricity to neighboring countries such as Poland, Czech Republic and Austria, which some claim has impeded those countries’ ability to develop local renewable energy sources.

The German government has taken steps to moderate near term growth of renewable capacity while the transmission network is brought into better alignment with output. None of the problems Germany is facing seem insurmountable over the long term, and America’s relatively greener credentials will probably be challenged. But given the political support for current policies in Germany, it’s notable how challenging they’re finding it to execute successfully.