Will rising interest rates hurt pipeline company stocks? Ten year treasury yields are at 3.25%, a seven year high. The bond market is commanding the attention of equity investors once more.

The high yields on MLPs have long attracted income-seeking investors. A common valuation metric is to compare the sector’s yield with the ten year treasury by measuring the yield spread. This is currently around 4.8%, compared with the twenty year average of 3.5%. In comparison, REITs and Utilities both have yield spreads under 1%.

While the MLP yield spread is historically wide, it’s been wider than average for almost five years, which probably means that the relationship has changed. Over the past decade it’s averaged 4.5%. MLP investors require a richer premium to other asset classes than in the past, which is why the bigger MLPs have been converting to corporations, so as to access a wider investor base (see Growth & Income? Try Pipelines).

While MLP yields have remained stubbornly high, they continue to move independently of the bond market. Visually, energy infrastructure and ten year treasuries have no relationship at all. The correlation of monthly returns is -0.35 over the past decade and 0.16 over the past five years – practically speaking, there is no correlation between the two.

Over short periods of time, fund outflows from income alternatives can depress MLP prices, but the effect is rarely enduring. Tariffs on regulated pipelines often include an inflation escalator, allowing increases pegged to the Producer Price Index (PPI), which creates some inflation protection for pipeline owners if inflation was to spike higher. This is why we often tell investors that the impact of higher rates depends on whether inflation is rising or not. If rising inflation drives up yields, the higher PPI will feed directly into higher revenues where contracts are correctly structured.

However, if rates move up independently of inflation (i.e. higher real rates), then all assets are affected. Any investment is worth the sum of its future cashflows discounted at an appropriate interest rate. Pipeline stocks would likely be affected like many other sectors.

But economic growth is very strong, which mitigates the effect of rates. Unemployment is the lowest in living memory at 3.7%. Everyone who wants a job has one, and demand is up for many things including pipeline capacity. The U.S. recently became the world’s biggest crude oil producer (see America Seizes Oil Throne).

Permian volumes in west Texas are overwhelming available pipeline capacity, which led to a price discount on Midland crude versus the WTI benchmark of as much as $17 in summer. It’s recently narrowed to $7 – still more than the typical contracted pipeline tariff, but less than the $10-20 cost of truck transportation.

Natural gas currently trades at around $3 per Thousand Cubic Feet (MCF). The natural gas basis between Waha in West Texas and the Henry Hub benchmark location is $2, meaning Waha natgas is worth only $1 per MCF. Permian gas output is 10 Billion Cubic Feet per Day (BCF/D), whereas pipeline capacity is only 8 BCF/D. Some of this excess production is flared, meaning it’s worth zero.

Unlike crude oil, natural gas can’t easily be moved by rail or truck because of the pressure required to compress it. Pipelines are the only option, and the price discount persists because the takeaway infrastructure isn’t available.

Anticipated Mexican demand is awaiting completed infrastructure south of the border. Futures traders expect the discount to persist for a while longer, which should benefit Kinder Morgan (KMI), Energy Transfer (ETE) and Oneok Inc (OKE). Beginning in 2020, additional capacity will be made available via KMI’s Gulf Coast Express and Permian Highway pipelines, adding around 4 BCF/Day.

Natural gas production is going to keep growing. Shell recently told investors they expect 2% annual growth through 2035, twice the growth in global energy demand overall. Although natural gas is often touted as being a bridge to a world of renewables, another energy executive said, “Gas not a transition fuel, but a destination fuel.”

The point is that these price differentials, which reflect unmet demand for additional pipeline capacity, are unlikely to be harmed by a modest rise in interest rates. The bond market is under pressure because the economy is booming.

Moreover, today’s battle-hardened MLP investors have endured several dozen MLP distribution cuts. The secular growth in U.S. hydrocarbon production is what attracts them (see Can Anyone Catch America in Plastics?). The companies themselves have also changed, with many of the biggest abandoning the MLP structure to become corporations (see The Uncertain Future of MLP-Dedicated Funds). As a result, broad energy infrastructure is less reliant on MLP investors (often older, wealthy Americans). The adoption of a corporate form, widely followed by the biggest MLPs and most recently by Antero Midstream GP (AMGP) has resulted in a broader, more institutional investor base.

The bottom line is that there’s little reason to fear the current rise in interest rates. Historically, there’s no statistical relationship between bonds and pipeline stocks. Output of oil, gas and natural gas liquids is rising, fueling demand for infrastructure. And the investor base is probably the broadest it’s ever been, as companies move away from the fickle MLP investor towards more conventional holders of U.S. equities. The broad-based American Energy Independence Index, which includes the biggest U.S. and Canadian energy infrastructure stocks, is up almost 2% in October even with treasury yields up 0.20%. So far, the sector has not been impacted by the headlines around rising rates.

We are long AMGP, ETE, KMI and OKE

Bethany McLean didn’t intend her latest book, Saudi America: The Truth About Fracking and How It’s Changing the World, to be a booster of the Shale Revolution. The New York Times got it all wrong when they titled her promotional op-ed, The Next Financial Crisis Lurks Underground. Before reading her book, I therefore assumed that in forecasting a collapse in the U.S. energy sector, the very recent one in 2014-16 had simply passed her by (see New York Times Forecasts the 2014-16 Energy Sector Collapse). But McLean accurately chronicles how OPEC nations failed to bankrupt the nascent U.S. shale industry with low oil prices, thereby demonstrating its resilience. She notes the importance of privately-owned mineral rights, an almost-uniquely American concept that facilitated onshore oil and gas exploration long before shale. Those who don’t fear a crash are well represented. The IEA’s chief economist, Fatih Birol, says, “There is a silent revolution taking place in the United States, so silent that nobody’s aware of it.”

In fact, McLean’s warnings of collapse are based on such weak arguments and are so half-hearted that she’s grudgingly conceding the secular change in world energy markets that’s occurring. A private equity investor (“titan”) suggests “…the Federal Reserve is entirely responsible for the fracking boom.” Really? Did the Fed buy energy sector bonds? Are low interest rates failing to benefit any other sector? In 2016, non-investment grade bond yields for some energy names reached 25%. Although there were bankruptcies, the industry survived as assets moved from weak hands to strong. She also finds some bearish hedge fund managers who have lost money shorting shale drillers. If these are the best arguments for another crash in the U.S. energy sector, investors have little to fear. In fact, the weakness of McLean’s arguments against Shale offered a more convincing defense of its longevity than many authors who set out to do just that.

As is often the case, the characters are most interesting. Although McLean relies heavily on past writings on Chesapeake founder Aubrey McLendon, it’s still absorbing to reread about his enormous risk appetite. McLendon’s fiery death while driving alone two years ago looked like suicide, given his mounting financial and legal problems, but it was ruled an accident. The industry lost a colorful believer whose single-minded approach was financially unsuccessful. By contrast, the methodical, analytical approach of companies like EOG demonstrates that the resurgence of hydrocarbon production in the U.S. is not driven by leveraged operators that are permanently bullish.

Shale firms have long been criticized for outspending their cashflow. The industry’s continued access to capital demonstrates that many expect this to reverse. The world’s biggest oil companies, like Exxon Mobil, are now investing in shale, bringing financial discipline and less reliance on capital markets financing, exactly what McLean believes is needed.

You have to work pretty hard to find a downside to American Energy Independence. It’s a bit like complaining about an outsized capital gains tax bill. Shale is pretty obviously an enormous U.S. benefit; less clearly good for others. Nonetheless, McLean tries to get us worried: if we buy less oil from unstable parts of the world, we’re less likely to care about their security. That’s not obviously bad for our young men and women in the military.

McLean fears that the Trump Administration’s desire to drill for oil in the Arctic National Wildlife Refuge (ANWR), “…will crater prices, thereby making the economics of drilling even less attractive than they already are.” Little thought went into that sentence – there are reasons to leave ANWR alone, but crashing the oil market is not one of them. This is where the real McLean emerges – as an environmentalist opposed to fossil fuels, trying to marshal non-environmental arguments against.

Having made a convincing if unintended case that financial challenges will not derail America’s energy renaissance, McLean then warns that renewables will soon bring its demise. But even here, she makes a strong argument for natural gas as a complement to intermittent solar and wind. She quotes Michael Cembalest, JPMorgan’s thoughtful chief strategist, who wrote that, “An electricity grid with less coal, less nuclear, and more renewable energy would be highly dependent on abundant, low-cost natural gas.” We completely agree.

The short-cycle nature of shale production is its enormous strength, something McLean overlooks. Predicting long term demand for crude oil is never easy, but the development of electric cars makes it exceptionally risky to invest in projects with a 20 year payback, which is what conventional oil projects look like. Shale production relies on drilling hundreds of wells that cost under $10MM each. Output declines sharply from a high rate, but capital invested is repaid quickly, often within two years. Output can be hedged in the futures market. If prices drop, drillers stop completing new wells. This quick payback offers a substantially better risk profile, something the industry recognizes. It’s why capital continues to flow in that direction (see Why Electric Cars Help the Shale Revolution).

Saudi America is a quick read – at only 138 pages, I finished it in around four hours. You won’t gain many insights, but as a chronicle of why the Shale Revolution will continue to transform energy markets, it’s worth a quiet afternoon.

Start with Iran. In May, Trump withdrew from the Nuclear Accord over strong opposition from foreign allies and domestic policy experts. America announced it would unilaterally impose sanctions on Iran from November 1. Critics said this would be ineffective. Since then, Iranian oil exports are down 25% and likely to fall further. Any company trading with Iran risks losing access to the U.S. banking system, a penalty sufficiently onerous that buyers of Iranian oil are wasting no time sourcing alternatives. Companies from South Korea, France, Japan, Greece, Spain and Italy have all reduced or halted purchases in recent months. U.S. oil and gas exports are a new weapon.

Coincidentally, this has also created an opportunity for exports of ultra-light condensate oil from Texas to meet Asian demand, with buyers increasingly shunning Iranian condensate. U.S. oil and gas exports are playing a bigger role.

The loss of Iranian crude oil on world markets has pushed prices higher. But the Shale Revolution has moderated the U.S. economy’s sensitivity to energy prices. The negative of consumers spending more on gasoline will be mostly offset by a resurgent domestic energy sector. The New York Times published a rare Trump-positive story, noting that the Iran strategy was working.

Germany’s heavy reliance on renewables to provide electricity has been hampered by its use of coal. Since it’s not always sunny and windy, solar and wind can’t provide a complete solution. In Germany, dirty coal-burning power plants provide the reliable baseload supply every electricity grid needs. Their emissions have negated much of the benefit of renewables, so Germany wants to burn more natural gas, which is cleaner. Its lower CO2 output makes it a natural complement to renewables (see Pipeline Investors Fight Climate Change).

Consequently, Germany is planning Nord Stream 2, a controversial pipeline that will bring natural gas from Russia to Germany. Trump is correct to ask, “What good is NATO if Germany is paying Russia billions of dollars for gas and energy?” But America can do more than just criticize; Liquified Natural Gas (LNG) from the U.S. provides an alternative not susceptible to mid-winter maintenance. Russia has used this tactic before, when negotiations with Ukraine weren’t going in the desired direction. Shivering Ukrainians found they had little leverage with Gazprom, Russia natural gas company, who is not an attractive supplier. Last week Trump promoted U.S LNG to Poland, another NATO ally.

In North America, the U.S. is providing more natural gas to Mexico, which needs it to meet growing demand for electricity. There is 11 Billion Cubic feet per Day (BCF/D) of pipeline capacity, of which Mexico is only using 4.5BCF/D. Meanwhile, the Permian in west Texas is producing more natural gas than the existing takeaway infrastructure can handle. This is limiting oil production (since gas and oil often both come out of the same well) and resulting in flaring of unused gas which nobody likes. As additional pipelines connect natural gas burning power plants south of the border, they will consume more Permian output.

Canada struggles with access for its oil exports, in part due to domestic politics (see Canada’s Failing Energy Strategy). This is why Transcanada’s (TRP) planned Keystone XL Pipeline is so important to them, since it will add up to 830,000 barrels a day of transport capacity for a country chronically short of it.

Trump overturned Obama Administration impediments to Keystone XL shortly after taking office. Although they’ve since had to contend with legal challenges at the state level, TRP expects to begin preliminary work on the pipeline in Montana later this year.

Marcellus natural gas is displacing Canadian imports in the eastern U.S., which is helping our trade balance at a moment when the Administration is focused on imbalances. Construction of Keystone XL is a big help to our northern ally. Energy is a vital component of our bilateral Canadian relationship.

Three quarters of global LNG trade occurs in Asia. Following Japan’s 2011 Fukushima earthquake and tsunami, they virtually shut down their nuclear power industry, which has made them big buyers of LNG. China and India are both looking for cleaner alternatives than coal to meet growing electricity demand. Although China recently imposed a 10% tariff on U.S. LNG imports, they previously exempted U.S. crude oil. China’s reduced purchases of U.S. LNG are being offset by other Asian buyers.

In June, U.S. crude oil exports reached 2.2 Million Barrels per Day (MMB/D). China bought almost a quarter, but other destinations included India and South Korea. We even exported 0.2 MMB/D to Canada, although they remain our biggest provider of crude with 4.5 MMB/D of different grades coming back the other way.

Exports of crude oil, natural gas liquids and LNG are all set to rise sharply in the years ahead, as new infrastructure is completed.

U.S. oil and gas exports are providing additional negotiating leverage over allies and adversaries. The Shale Revolution and energy infrastructure investments are providing vital support.

On July 6, 2013, 47 residents of Lac-Megantic, Quebec died horribly when a 74-car freight train carrying crude oil exploded in a fireball. It was the deadliest freight-train accident in Canadian history. Five bodies were never recovered and were assumed to have simply vaporized. DNA samples were required to identify others. Heat from the inferno was felt over a mile away.

In spite of this tragedy, moving crude by rail (CBR) is comparatively safe. Since 2013, safety standards have been tightened throughout North America. The International Association for Energy Economics (IAEE) found the incidence of spills with CBR to be less than for pipelines. However, this is a deceptive statistic. Once you adjust for the greater volumes of crude moved by pipeline versus CBR, as well as the greater distances covered, pipelines remain substantially safer. The report concludes that, “the risk associated with shipping crude oil is noticeably larger for rail deliveries than for pipeline deliveries.”

2,500 miles west, off the coast of Vancouver, live around 75 endangered killer whales. Their connection with Lac-Megantic is not obvious. Fortunately for the Orcas, vocal advocates have successfully made their continued survival more important than avoiding another freight train tragedy. By blocking the Trans Mountain Pipeline Expansion, they have ensured that more Albertan crude oil will reach its buyers by rail, given continued inadequate pipeline capacity.

The Trans Mountain Pipeline (TMX) was put into service in 1953, and has been in continuous operation ever since. It’s another example of the long life of installed energy infrastructure, which generally appreciates in value when properly maintained even while accounting rules allow for its depreciation. Kinder Morgan (KMI), which acquired the pipeline in 2005, had been frustrated in its efforts to more than double the capacity of TMX by adding a second pipeline alongside the first. The TMX Expansion’s approval became a provincial political football. Land-locked Alberta has few choices in exporting its crude oil.

British Columbia sought to prevent a new pipeline from Alberta reaching the Port of Vancouver. Oil that passes through on its way to export markets has little value to local residents, since British Columbia doesn’t need any more oil. Environmentalists worried about a spill, and regard Albertan oil-sands crude as exceptionally hostile to the environment (it’s true that an oil sands facility is not pretty). First Nations tribes claimed their water supplies were threatened, although of 133 indigenous groups consulted, 43 were in support. And the anticipated increase in tanker traffic at the port of Vancouver, from two to ten per week, risked displacing the dwindling community of killer whales.

It was this last point that prompted the Federal Court of Appeal to overturn the government’s approval of the expansion in late August. Although the absence of a meaningful dialogue with First Nations representatives was cited, failure to consider the increased tanker traffic, “was so critical that the Governor in Council could not functionally make the kind of assessment of the project’s environmental effects and the public interest that the (environmental assessment) legislation requires,” said the ruling, written by Justice Eleanor Dawson. Canadian law provides wildlife with considerable protections.

In a deft move, KMI had by now extricated themselves from the vagaries of Canadian energy policy. For months, they had complained about the impossibility of building a pipeline linking two provinces holding opposite views on its completion. Finally, in May they unburdened themselves of the whole sorry mess and sold TMX to the Canadian Federal government for C$4.5BN, viewed by many as a pretty full price. KMI shareholders dodged a bullet.

A few weeks after agreeing the sale of TMX, KMI estimated in a filing that completion of the expansion would cost C$1-1.9BN more than originally expected and take a year longer. On August 30^th, KMI shareholders formally approved the sale, hours after the Court of Appeal ruling. TMX was by now worth considerably less than the C$4.5BN paid — the bailout by Canadian taxpayers was complete.

Prospects for the TMX Expansion are uncertain, with a delay of two years or more seemingly inevitable. The Canadian government is considering an appeal, redoing its environmental review, and crafting legislation to force it through. Canada wants to complete the pipeline. Meanwhile, Alberta grumbles about contemplating separatism, and has in the past suggested that it might halt crude oil shipments to British Columbia altogether.

Canadian crude oil will continue to reach its buyers, although more of it will move by rail. The International Energy Agency expects CBR shipments to double over the next two years due to lack of pipeline capacity. Suncor, Canada’s largest oil and gas producer, won’t expand crude oil production until it sees progress on pipeline approvals. The persistent $25-35 per barrel discount of Western Canadian Sedimentary crude to the WTI benchmark is directly linked to limited transportation choices, and must be regarded as a huge success by Alberta’s neighbors in British Columbia. Since the U.S. is both its biggest energy customer and nowadays its biggest competitor, Canada’s position is unenviable.

American readers will be relieved that such extreme dysfunction doesn’t exist in the U.S. Recall though, Boston’s annual winter imports of liquefied natural gas from Trinidad and Tobago to keep the lights on.  Pipeline opposition isn’t limited to our northern neighbor (see An Expensive, Greenish Strategy).

The investment takeaway is that opposition to new pipelines increases the value of those already installed. When shippers resort to rail to move crude oil, their bargaining position on pipeline tariffs is weak. Oil and gas companies suffer lower revenues, consumers higher prices, and railway lines benefit if demand is sustained long enough to justify their capex. But for pipeline companies, installed pipelines with decades of useful life can represent a scarce resource. If the possibility of excess pipeline capacity concerned markets during the 2014-16 energy sector collapse, we are now headed solidly in the other direction.

We are long KMI.

Before jumping at an attractive yield, investors should pause to consider its consistency.

In recent years, traditional MLP investors were victims of one of the greatest betrayals in U.S. financial history. Older, wealthy Americans were drawn to companies that paid out most of their cashflow in distributions. For years, America’s energy came from roughly the same places in the same amounts, which meant little need for pipeline operators to re-invest in the business. The Shale Revolution changed all this – new sources of oil and gas required new infrastructure (see Will MLP Distribution Cuts Pay Off?).

MLPs decided to grow, redirecting cashflows from payouts to new projects. K-1 tolerant, income seeking investors were the quintessential long term buyer sought by every CEO. All they wanted was stable income. Although for years MLPs provided this, in 2014-15 many of them seized the opportunity to be growth businesses, which redirected cash away from investors. Alignment of interests was lost. MLPs in aggregate demonstrated that Distributable Cash Flow would be paid to investors only as long as they didn’t have any better uses for it. Payouts were cut, trust was shattered. Today’s sector remains 28% below its August 2014 high, and its recovery offers something for everyone (see Growth & Income? Try Pipelines).

Stable and growing dividends remain highly valued. Although the Alerian MLP ETF (AMLP) has cut its distribution by 30% (see It’s the Distributions, Stupid!), Alerian used to post a chart with 6% average ten year distribution growth.  Index components change, and Alerian was using the historic growth of existing index members regardless of how long they’d been in the index. This introduced a survivor bias, in that MLPs cutting distributions used to be dropped while the newly IPO’d ones they added were typically growing quickly. This confused many, because it failed to match actual investor experience. It seemed that everyone but Alerian knew MLP distributions were being cut. Facing growing criticism (see MLP Distributions Through the Looking Glass), Alerian revised their chart to better match reality.

However, energy infrastructure overall has provided far more distribution stability than shown by MLPs. The American Energy Independence Index consists of the biggest pipeline companies in America, which are mostly corporations although it includes a few MLPs as well. It yields 5.5% based on 2018 dividends, a payout that is up 10% on 2017. We expect dividend growth of almost 11% next year. While income seeking investors are naturally drawn to attractive yields, the reliability of the payout is critical.

The chart shows that Alerian MLP Index dividends fell far more than for energy infrastructure as a whole. Moreover, they still have a long way to recover back to the levels of 2014. Although we think MLP distribution cuts are mostly behind us, the group’s history is one that income seeking investors shouldn’t soon forget. By contrast, American Energy Independence Index dividends dipped but quickly recouped their losses. The members of this index have demonstrated far more reliability with their payouts.

The Alerian MLP Index yields 7.3%, although it’s only accessible via structurally flawed MLP-dedicated funds that pay corporate tax (see The Tax Drag on MLP Funds). Because tax expense for such funds flows out of their NAV, in reality, the yield is lower. The energy infrastructure sector’s 5.5% yield is accessible through conventional, RIC-compliant funds with no tax drag. Corporations have managed their cashflows, including payouts, far more reliably than have MLPs. Moreover, those lower payouts have meant more retained earnings to be reinvested back into their businesses.  This is what will drive the 10% annual dividend growth we expect 2017-19, a level MLPs failed to achieve even in the boom years leading up to the 2014-15 collapse.

As the second chart shows, when payouts are cut less in the short run, they grow faster over the long run. Energy infrastructure is a growth business that offers attractive yields. Investors who favor companies with a reliable history of dividends are likely to fare better.

We are short AMLP.