A few weeks ago we wrote Why Oil Could Be Higher for Longer, and since then it has elicited quite a few comments back to us from clients and blog subscribers. We won’t repeat it in detail here since readers can simply click on the link above to see it. But our view is that the outlook for U.S. crude production over the intermediate term is very constructive, and certainly better than current consensus. This relates to the superior economics of shale wells compared to conventional drilling, and the associated ability of shale Exploration and Production (E&P) companies to quickly respond to changing prices by adjusting drilling activity faster than their peers.

“Shale wells,” (i.e horizontal wells drilled into source rock and stimulated by fracking) have many competitive advantages over conventional wells that give us confidence American production of Oil, Natural Gas Liquids (NGLs), and Natural Gas will greatly exceed consensus expectations to meet new energy demand and fill the void left by depleting fields.

A recent article in the Financial Times expanded on this theme (U.S. shale is lowest-cost oil prospect). A chart accompanying the article showed the break-evens of twenty potential future projects and the cheapest half-dozen are U.S. shale plays. In fact, shale oil development benefits from many of the advantages that are inherent in the U.S. Most Americans take for granted that property ownership comes with mineral rights for anything found below their property, but around the world this is by far the exception. In most countries mineral rights belong to the government. Getting a farmer to agree to allow drilling on his land is easier if he’s able to negotiate a monthly royalty check as opposed to a central authority simply exercising its control.

Although many of the cheaper sources of new oil are U.S. shale, Wood Mackenzie doesn’t believe there’s enough to satisfy the world’s consumption at current prices. Depletion of existing fields plus new demand create a need for roughly 6MMBD (million barrels a day) of additional supply annually. The market will clear at the marginal cost of the most expensive barrel needed to balance the market – a price that looks a good bit higher than today’s spot price. And for those who think offshore drilling can be attractive, BP just announced the final charge of $5.2BN for the 2010 Deepwater Horizon spill in the Gulf of Mexico. Their total costs for this one incident add up to $61.6BN, a hit only a few global companies could absorb. You can be sure that any offshore drilling in U.S. continental waters has to account for this possibility in its risk analysis.

Critically, low-cost U.S shale wells can be drilled much more quickly and come on with significantly higher initial production (IP) rates with steep decline curves.  In fact, a new shale well can go from planning to full capital payback before most new conventional  projects are even producing.  This fast decline rate also allows shale oil producers to hedge the bulk of their production, which occurs in the first several years, in the futures market which is only liquid for a few years out.  It’s worth noting that the quicker the payback the quicker shale E&Ps can plowback cash into new shale drilling. The chart below from the U.S. Energy Information Agency highlights how IP rates have improved over the past few years (click on image to expand).

 

Geographically, the U.S. is blessed with generally sufficient water supplies close enough to the shale plays that they support, since fracking requires a lot of water. Entrepreneurial drive is as strong a force in America as anywhere, and that combined with highly developed capital markets make access to financing and substantial wealth accumulation possible for those who are able to profitably exploit this resource. And continued technological innovation spurred by entrepreneurs is relentlessly driving costs down faster than most expected and faster than conventional plays, further increasing their competitive cost advantages, playing to another American strength.

Even with all the American advantages and helped by the tailwind of high commodity prices it still took a decade for shale drilling to have a meaningful impact on output. Major shale drilling anywhere outside the U.S is a long way off, providing a huge first mover advantage.

In other words, the shale revolution is occurring because of all these inherent strengths in the U.S. On top of which, energy independence which is where we’re heading as a result, is in our national interest and highly likely to remain that way. The entire story is built on U.S. advantages and oriented towards U.S. interests. From a strategic perspective, given what we know today, it seems to us that perhaps the best secular investment theme available is the continuation of this trend, to the obvious benefit of the midstream infrastructure Master Limited Partnerships (MLPs) whose support is critical.

It’s no longer the case that a distribution cut is bad for an MLP. In April, Crestwood Equity Partners (CEQP) cut its distribution at the same time as announcing a JV with Con Edison and steps to reduce its leverage (see Crestwood Delevers and Soars). Last week Plains GP Holdings (PAGP) announced a simplified structure with its MLP Plains All America (PAA) and an 11% distribution cut at PAGP. Both stocks moved sharply higher on a perceived lower cost of capital and therefore improved growth prospects. Williams Companies (WMB) is likely to cut its dividend so as to reduce leverage, but at a 12% yield there can be few who would be surprised by this. A distribution cut in support of a stronger balance sheet seems to attract more buyers than sellers nowadays.

Lastly, we note that Shell Chemicals is investing $6BN in a new ethylene facility in SW Pennsylvania near Pittsburgh (artist’s impression from Shell at left). It’s located there to be close to its supply of ethane in the Marcellus and Utica shale areas, of which it expects to consume 90-100 thousand barrels a day. The facility will in turn produce 1.5 million tonnes per annum (MTPA) of ethylene and 1.6 MTPA of polyethylene, widely used in everything from food packaging to automotive components. This is not a region that has seen a new large industrial project such as this in living memory. It’s another example of the tangible results of the shale revolution.

We are invested in CEQP, PAGP and WMB

As regular readers know, the proposed merger between Energy Transfer Equity (ETE) and Williams Companies (WMB) has been a rich source of material. Last week a judge’s ruling enabled ETE to cancel the deal since a needed tax opinion was not forthcoming. WMB found it convenient to say the least that ETE’s tax counsel Latham Watkins, having originally provided informal guidance that no adverse tax outcome was likely, later changed their minds coincident with their client souring on the deal. However, Judge Sam Glasscock III found no coincidence and absent a tax opinion that the deal was tax-free, ETE had its escape hatch.

We didn’t think the deal would get done, but we remain interested in the fate of the convertible preferred securities ETE issued in March. As we wrote before (see Is Energy Transfer Quietly Fleecing Its Investors?), a select group of ETE insiders representing 31% of the common units outstanding was given the opportunity to swap their units for preferred securities with a guaranteed dividend which could be reinvested in more common units at $6.56 per share (ETE closed Friday at $13.80). Ostensibly this was to shore up ETE’s balance sheet given the $6BN cash payout they had agreed to under the merger. But it had the additional result of devaluing ETE units for all the other holders, including WMB investors who would be receiving new securities linked in value to ETE. WMB naturally sued. This looked like a very aggressive, almost scorched earth negotiating strategy by ETE in their efforts to force a renegotiation on WMB. However, as we noted in May, ETE CEO Kelcy Warren indicated that these securities would remain outstanding even if the merger was cancelled.

WMB’s lawsuit of these securities didn’t receive a ruling from Judge Glasscock. He recognized his ruling on the tax opinion was likely to scupper the deal anyway, rendering WMB no longer an injured party. However, the same judge is hearing a lawsuit on this issue from other plaintiffs.

Without doubt, the abovementioned securities represent fraud by ETE’s management. Every ETE investor would welcome the opportunity to swap their common units for the ones Kelcy and his friends own. He has a fiduciary obligation to other ETE investors which this action clearly violates, transferring substantial value (we estimated $1.3BN) from investors in the same class of units to the insiders. Since ETE no longer faces the prospect of finding $6BN, the apparent need for the securities themselves has disappeared and we await their cancellation.

So we’re watching to see if ETE  acts with integrity and voluntarily cancels the convertible preferreds. Or will they seek to retain this wealth transfer with a different justification? It’s going to be hard for ETE to negotiate future deals credibly following the WMB experience, but especially so if they choose wrong on this issue. One can forgive the second thoughts on the merger, because the market moved sharply against MLPs last year. This was an issue of judgment. But a CEO who openly defrauds his public partners has lost his reputation for good. What use to the world is a dishonest billionaire, beyond donating his money to have a couple of buildings named after him? In future dealings with Kelcy and the other insiders, including John McReynolds (President of ETE’s General Partner), Matthew Ramsey (President of Energy Transfer Partners), Marshall McCrea III (Group Chief Operating Officer) and Ray Davis (retired, co-founder), you’d always have to assume that they could once again fail to act in good faith having done so before. Based on the data we analyze about our blog subscribers, we know senior managers at ETE are reading this.

It may surprise, but we remain invested in ETE. We believe Kelcy Warren will cancel these securities. He and his team have built a fantastic business. They are enormously talented. They can avoid any loss of face by simply saying the securities are no longer needed. This is the right thing to do. You won’t find any sell-side analysts asking tough questions on this issue out of fear of causing offense. At SL Advisors we are free to say what many other analysts are merely thinking, because our only interest in ETE is that its value appreciate and its stock price rise. In this way, we are completely aligned with our clients and free to call it as we see it.

Kelcy, do the right thing.

We are invested in ETE and WMB

The Energy Transfer-Williams merger continues to be a bizarre spectacle. While the Williams (WMB) Board in an SEC filing noted that a majority was in favor of the merger, their body language says otherwise. They are speaking in code. The filing notes that anticipated synergies from the transaction are virtually zero and that the new ETC stock for which WMB holders will exchange their shares will not pay a dividend for two years. On top of this, three former CEOs of WMB published a letter noting the move by Energy Transfer Equity (ETE) CEO Kelcy Warren to dishonestly enrich himself at the expense of other unitholders (see Is Energy Transfer Quietly Fleecing Its Investors?). They emphatically recommended against the merger. WMB has complied with the merger agreement by recommending a YES vote, but that’s a technicality, required to avoid a $1.48BN break-up fee. Neither company wants to do the deal, but both want to avoid triggering penalties or legal liability for failing to close. WMB even disclosed in a subsequent SEC filing that a dividend cut was likely if they remain independent, so for WMB holders it appears that in either case payouts will be smaller. The stock barely retreated on this news – perhaps the 12% free cashflow yield already provides sufficient support.

We read between the lines and voted NO. We’re comfortable with our modest exposure to Kelcy Warren, but don’t wish to increase it by trading in our WMB stock. We are invested in ETE and WMB.

The chart below is a helpful visual that puts recent moves in the Alerian Index into perspective. The 2015 MLP Crash (which looks like it ended on February 11, 2016) looks similar to the 2007-08 Financial Crisis, at least in terms of the price moves. For much of 2015 MLPs endured their own personal market disaster while other sectors of the equity market outside of energy paid little heed. At 58.2% it was the biggest drop in the Alerian Index’s history, going back to 1997. For those who find such comparisons useful, big drops in the sector have been followed by proportionately big recoveries. So for example, the 52.3% drop in 2007-08 was followed by a 139% recovery over the following two and a half years. As the chart shows, if past is prologue there’s still a long way to go. As we are frequently reminded though, past performance is not indicative of future results.  Therefore, our constructive outlook on the sector is predicated on fundamental supports such as valuations and the positive long-term outlook for U.S. hydrocarbon output as we head towards energy independence.

Examining the Risk Factors in a company’s 10-K is not everybody’s idea of light entertainment, but as you’ll see below it can provide useful insight about how management may treat certain of its stakeholders.

Many Master Limited Partnerships share a legal structure that is similar to hedge funds and private equity funds, in that the investors put their money in the fund whereas the manager gains most of his wealth from controlling the General Partner (GP). MLP investors don’t think of themselves as hedge fund investors, and to be sure the 9% ten year annual return on the Alerian Index is far better (for example, the HFRI Fund-Weighted Composite Index has only managed 3.3%), including as it does both the 2008 Financial Crisis and the 2015 MLP Crash.

But from the perspective of governance rights, MLP investors do look a lot like the passive Limited Partners (LPs) in these other asset classes. They surrender many of the rights taken for granted by equity investors in public corporations. Here are some examples lifted directly from the relevant 10-K. It’s one of the reasons why MLP managements typically invest in the MLP GP rather than the MLP itself, and it’s why we do too.

Williams Partners (WPZ)

“Our general partner has limited duties to us and it and its affiliates, including Williams and Access Midstream Ventures, and may have conflicts of interest with us and may favor their own interests to the detriment of us and our common unitholders.”

“…Williams’ directors and officers have a fiduciary duty to make decisions in the best interests of the owners of Williams, which may be contrary to our best interests and the interests of our unitholders.”

“Except in limited circumstances, our general partner has the power and authority to conduct our business without unitholder approval.”

“Our general partner may cause us to borrow funds in order to permit the payment of cash distributions, even if the purpose or effect of the borrowing is to make incentive distributions.”

“Our partnership agreement limits our general partner’s duties to unitholders and restricts the remedies available to such unitholders for actions taken by our general partner that might otherwise constitute breaches of fiduciary duty.”

“Holders of our common units have limited voting rights and are not entitled to elect our general partner or its directors, which could reduce the price at which the common units will trade.”

“Even if public unitholders are dissatisfied, they have little ability to remove our general partner without the consent of Williams.”

“Our partnership agreement restricts the voting rights of unitholders owning 20 percent or more of our common units.”

Explanation: The management of WPZ has no fiduciary obligation to WPZ LPs, can cause WPZ to borrow money in order to pay management, and can’t be fired.

 

Plains All American (PAA)

 “Unitholders may not be able to remove our general partner even if they wish to do so.”

“…generally, if a person acquires 20% or more of any class of units then outstanding other than from our general partner or its affiliates, the units owned by such person cannot be voted on any matter.”                                                                                                                                                          

Explanation: You can’t fire the management of PAA either.

 

Energy Transfer Partners (ETP)

“Unitholders have limited voting rights and are not entitled to elect the General Partner or its directors. In addition, even if Unitholders are dissatisfied, they cannot easily remove the General Partner.”

“Unlike the holders of common stock in a corporation, Unitholders have only limited voting rights on matters affecting our business, and therefore limited ability to influence management’s decisions regarding our business.”

“Furthermore, if the Unitholders are dissatisfied with the performance of our General Partner, they may be unable to remove our General Partner. The General Partner generally may not be removed except upon the vote of the holders of 66 2/3% of the outstanding units voting together as a single class, including units owned by the General Partner and its affiliates. As of December 31, 2015, ETE and its affiliates held approximately 0.5% of our outstanding Common Units and our officers and directors held less than 1% of our outstanding Common Units. Furthermore, Unitholders’ voting rights are further restricted by the partnership agreement provision providing that any units held by a person that owns 20% or more of any class of units then outstanding, other than the General Partner and its affiliates, cannot be voted on any matter.”

Explanation: You can’t put the people you’d like in senior management positions, and you can’t fire us.

 

These three names were selected simply because they’re well-known. Such provisions are not uncommon, and they do at least provide plain disclosure. If you’re not happy with your private equity manager you have very limited recourse; you can’t easily fire him and you have to wait for liquidity events to get your money back. At least if you dislike the management of your MLP you can sell your position.

Like the management teams that run these three MLPs, we are invested in the GPs of these as well as others. We are generally supportive of the people that run them, although we withhold judgment for now on one (see Is Energy Transfer Quietly Fleecing its Investors?). Even if you don’t expect management to fully avail themselves of the powers they’ve granted themselves, it’s good to know what those powers really are.

We are invested in Williams Companies (WMB), Plains GP Holdings (PAGP) and Energy Transfer Equity (ETE).

Please note publication of our June newsletter will be delayed by a few days as I’ll be attending the 2016 MLP Investor Conference in Orlando.

 

Last week Linn Energy (LINE) filed for bankruptcy. Over the past year or so we’ve come across quite a few people whose exposure to Master Limited Partnerships (MLPs) regrettably included LINE. They were attracted by the yield, whose steady rise until 2013 belied the unpredictability of their cashflows. LINE was engaged in Exploration and Production (E&P), and so they were always going to be a bet on the price of crude oil. The company bought acreage when crude was at $100, so it was always going to be challenging for them once it collapsed. The stability of their distribution didn’t reflect economic reality.

Back in 2013 there were also questions raised in Barrons about LINE’s accounting treatment for options that were used to hedge their output. The SEC subsequently investigated. We typically avoid E&P companies anyway, but whether the criticisms of non-GAAP treatment were justified or not, LINE wasn’t making it easy for investors to analyze their financial statements. Their website, which now includes information on their restructuring, says, “LINN Energy’s mission is to acquire, develop and maximize cash flow from a growing portfolio of long-life oil and natural gas assets.”

MLP investors were originally seeking stable income, although the 2015 rout has in our opinion created the most deeply undervalued sector in the equity markets. A cute bit of Math is that a 2% drop in yields (through price appreciation) will generate no less than a 30% total return[1] over one year for any equity sector (or individual equity security). Only MLPs offer this kind of potential.

Although E&P companies can and do structure themselves as MLPs, their returns are ill-suited to the traditional MLP investor base. During 2014-15 every single E&P MLP in the Alerian Index cut or eliminated their distribution. This drove the drop in distributions on the index and fueled fears of further distribution cuts across the rest of the sector. The rules under which the index is constructed require that a distribution cut causes the offending name to be ejected from the index, so although there are still E&P MLPs, the leading index has gradually been relieved of their burden.

Because MLPs normally pay out most of their cashflow, an E&P business is particularly ill-suited to this form of organization. If you own an asset (crude oil in the ground) and you distribute the net proceeds from its extraction to your equity investors, your underlying asset base is depleting. You may confuse the issue by investing in new crude oil acreage with new capital raised, but eventually the music will stop. The collapse in crude kicked the CD player off the chair sooner than expected for some, but it’s not a sustainable model.

This contrasts with owning an asset that’s appreciating, such as an installed pipeline whose replication becomes ever more expensive as development goes on around and above it. Many pipelines would cost multiples of their original cost to build today with population centers having grown up, easements harder to obtain and regulatory approvals ever more demanding. This is a business built on sending back the recurring cashflows earned from renting out its capacity.

Both business models, the depleting asset and the recurring cashflow from rented capacity, can legally exist as MLPs. But they’re not to be confused with one another. The market dislocation of last year is cleansing the sector of weaker models, leading to a quality upgrade. LINE was the wrong kind of MLP. Their distributions were the result of using up their reserves in the ground. In effect, they were returning capital to investors rather than profits, although the collapse in crude oil hastened their demise. While it was unpleasant for investors in LINE, they’ll better appreciate the more secure foundation of their other MLP holdings.

[1] For example: a security priced at $6 pays a $0.60 dividend, yielding 10%. Over the next year its price rises to $7.50, causing its yield to drop to 8%. The $1.50 price gain plus the $0.60 distribution equals a $2.10 return on the original $6 investment, or 35%.