Why aren’t MLPs performing better given the fundamentals? On valuation, they should be compelling. Using EV/EBITDA (Enterprise Value /Earnings Before Interest, Taxes, Depreciation and Amortization), they are virtually on top of utilities, a point not reached either in 2008 or 2016.

Typically, MLPs are valued at a higher multiple. Although like utilities, they depreciate their assets, unlike power plants, pipelines buried underground typically appreciate, since their cashflows grow. They also have more flexibility in their customer base, since a pipeline can move hydrocarbons from anywhere that’s connected by the network. The customer base of a utility is geographically fixed. And EBITDA generated by a utility is subject to taxes, whereas MLPs don’t pay tax. For all of these reasons, EV/EBITDA multiples for MLPs are usually higher. Consequently, when relative valuations approached one another as they have twice briefly in the past decade, a sharp recovery in MLPs followed.

The yield on the Alerian MLP Index is currently 7.8%, 5.6% above the ten year treasury and substantially wider than the 15 year average of 3.5%. Moreover, MLP debt is performing far better than their equities, suggesting no particular financial distress.

2Q17 earnings were largely uneventful, with the dramatic exception of Plains All American (PAGP) which warned of a likely distribution cut (see MLP Investors Learn About Logistics). Management teams report that business is fine, cashflows growing and product moving. At some point in the next year we’re likely to see U.S. crude oil production exceed 10 Million Barrels per Day, a record last seen in November 1970. Yet MLPs fall when crude prices are weak and seem indifferent when they rise. What is going on?

MLP investors originally signed up for high, stable distributions with modest growth and not much excitement. The widely-hated K-1s provide a useful tax deferral for those willing to hand them off to an accountant. The tax benefit accumulates over time, creating a powerful incentive to delay selling which would make the tax bill come due. Some MLP investors really do hold forever, or at least their lifetimes, leaving their heirs to benefit from a stepped-up cost basis that wipes the tax slate clean. In a world of trigger-happy equity analysis with a relentless focus on the next few days or hours, MLP investors are what every company says they want: in for the long term.

There is increasing evidence that this stable investor base has been turning over. The Shale Revolution created the need for more infrastructure to support America’s drive to energy independence. It’s a truly exciting story that exemplifies much that is great about the U.S. (see Why the Shale Revolution Could Only Happen in America). But quite a few managements in their drive to seize the ensuing growth opportunities have imposed an unwelcome financial model on their loyal investor base. Stable distributions with low growth were put at risk with increased leverage seeking faster growth. The result, as Kinder Morgan showed, was that the MLP structure doesn’t work if you’re big and need to fund large capital projects.

The consequence for Kinder Morgan Partners (KMP) investors was an unwelcome tax bill as their units were absorbed by Kinder Morgan Inc. (KMI), and ultimately two dividend cuts. KMI recently announced they’ll be raising their dividend next year, since their backlog of new projects is a fraction of what it was three years ago and so they have more cash available to resume higher payouts (see What Kinder Morgan Tells Us About MLPs). But the psychological damage to KMP investors has been done. Every financial advisor I talk to has some clients who owned KMP and were effectively betrayed. They never signed up for higher leverage in search of faster growth, but the stewards of their capital decided for them. The experience has made many long-time MLP investors wary of being seduced by valuations into committing new capital.

KMI was only the first. Other companies, including Targa Resources (TRGP), Plains All American (PAGP), Oneok (OKE), Williams Companies (WMB) and Energy Transfer (ETP) have undertaken various types of structural simplification. In every case, it was a result of growth that strained balance sheets and it ultimately led to a cut (sometimes two) in distributions to MLP investors, an unwelcome tax bill or both. PAGP warned of an impending second distribution cut earlier in the month. The most loyal investors in the public equity markets have had their trust abused by management teams whose choices ultimately risked the stable payouts their clients had always sought. Although no reliable figures exist on this topic, several MLP executives have admitted to substantial turnover in their investor base in recent years. Income seeking investors did not sign up for this. The 58.2% drop in the Alerian Index from August 2014 to February 2016 remains a recent, highly unpleasant memory. When combined with multiple cases of broken distribution promises, many long-time MLP holders feel abandoned. The investor base is changing.

That is what is creating the current valuation opportunity. Today’s investors in energy infrastructure like the yields but are also fine with cash being reinvested back in the business, something MLPs did on a much smaller scale in the old days. Recent buyers recognize the opportunities to grow cashflows through enhancing existing assets and building new ones at attractive IRRs. The Shale Revolution is a tremendous opportunity for energy infrastructure businesses to generate stable and growing cashflows for many years ahead. But financially, getting there has been highly disruptive for an investor base originally not much concerned with growth. This transition from one type of investor to another isn’t happening smoothly, but it’s happening.  Valuation discrepancies such as the EV/EBITDA comparison with Utilities won’t last forever.

We are invested in Energy Transfer Equity (General Partner of ETP), KMI, OKE, PAGP, TRGP and WMB

 

 

We hear so often how energy infrastructure is all about pipelines and storage assets with fee-based contracts that when another part of the business pops up it can cause quite a stir. So it was that Plains All American (PAGP), one of the biggest crude oil pipeline operators in the U.S., provided an unwelcome example of the uncertainty surrounding one aspect of their business. Accelerating changes in the marketplace adversely affected their Supply and Logistics segment, such that PAGP thought it worthwhile holding their Wednesday morning earnings call on Tuesday evening, immediately following their earnings release.

Supply and Logistics involves taking temporary ownership of crude oil, Natural Gas Liquids (NGLs) and natural gas with the objective of unloading it elsewhere for a profit. The idea is not to make money from price moves, but rather to generate a profit from known inefficiencies in the transportation network. If you can buy crude oil at point A for $45 a barrel and sell it at point B for $48 while spending less than $3 on storage, transportation and overhead, it can be a profitable business. It has been so in the past; in 2013 PAGP generated $893MM in EBITDA from this activity, although its profits have been declining since. It is in effect a profit from inefficiency of the domestic transport network. If crude is worth $3 more at point B compared with point A, the cost of transport should be around $3, or crude will flow until the arbitrage is eliminated.

The problem, as PAGP belatedly discovered, is that the market is becoming more efficient. Three years ago Congress lifted the ban on crude exports, which removed one significant inefficiency. Patches of excess pipeline capacity further challenged arbitrage opportunities by providing shippers with more choices. More recently, a flattening of the crude oil futures curve along with lower volatility reduced opportunities, as did more competition. Several other firms have de-emphasized or exited the business over the past couple of years.

The deep disappointment no doubt felt by PAGP CEO Greg Armstrong and those who know him is that they didn’t see this coming. Plains is better positioned than most to see first-hand changes in the supply and logistics of hydrocarbons. They pride themselves on a very sophisticated view of shifts in the marketplace. Three months ago a weak first quarter in this segment was partly blamed on warm winter weather. Propane held in inventory anticipating stronger prices had to be sold on weakness.

The outlook for profits in Supply and Logistics is so uncertain that PAGP says they’ll likely exclude it from their calculations of Distributable Cash Flow (DCF), the metric underpinning their distribution. They’re currently forecasting only $75MM this year. Although a strategic review is underway and will likely take a couple of months, the Facilities and Transportation businesses can only support a payout of around $1.80 per share (albeit with 1.1X coverage), down from $2.20 currently. Plains cut their distribution last year when combining their MLP and GP, so this likely represents a second cut in two years. Another management team’s reputation is shredded. Greg Armstrong will not care to be compared with Rich Kinder who also oversaw two dividend cuts in as many years at Kinder Morgan, but many investors will see little between them. In both cases a seasoned CEO has been shown to poorly anticipate changes in a business in which he’s spent his entire career. If Greg Armstrong didn’t see it coming, it’s hardly surprising that PAGP investors didn’t either.

We are invested in PAGP

The Prize: The Epic Quest for Oil, Money and Power was first published 27 years ago, although Daniel Yergin added an Epilogue in 2008. It is nothing less than an economic and political history of crude oil. At 910 pages of text and footnotes it’s an epic read, but you can select sections of interest and jump around, leaving and returning to it later. The very beginnings of the U.S. oil business were about producing kerosene from “rock oil” to replace whale oil or turpentine used for light. Its illuminative qualities were deemed far superior to the alternatives and production took off in the early 1860s. The Civil War boosted demand and the oil business had begun. John D. Rockefeller became the richest man in America by selling kerosene.

During the early 1900s the internal combustion engine created a new market for gasoline, promoting oil in importance over coal as a source of primary energy and leading Daniel Yergin to dub the 20th Century “The Age of Oil”.

The 1973 Oil Shock is a distant memory for those of us old enough to have any first hand recollection. It’s therefore quite sobering to re-familiarize oneself with its history as recounted by Yergin in 1990 when its ramifications remained fresh. Iconic photos of cars lined up outside gas stations were a vivid reminder of modern society’s dependence on oil; they also exposed the western world’s sudden vulnerability to an adverse clash of politics and economics in a volatile region.

Reading about events some 44 years later, the ability of Arab oil producers to turn a spigot so as to influence U.S. policy decisions was outrageous, an affront. The history of how OPEC came to wield such power is well recounted by Yergin. From 1948-72, 70% of newly discovered proved oil reserves were located in the Middle East. This concentration of oil resources combined with western governments’ inattention to their increasing reliance on monarchs with whom their interests were not aligned created the conditions under which the Arab Oil Embargo was so effective.

Countries were placed on one of three lists (Friendly, Neutral or Unfriendly) depending on how closely their public policy statements pleased Arab oil suppliers, with deliveries modified commensurately. Europe produced very little oil and Japan virtually none. By contrast, U.S. production reached 9.5 Million Barrels per day (MMB/D) in 1973, coincidentally, a record we will soon eclipse.

Although America wasn’t self-sufficient, it wasn’t as reliant on OPEC as others. However, strong domestic demand had caused imports to almost triple over the prior six years, to 6 MMB/D, so energy independence was not a realistic objective. Over the prior quarter century the U.S. share of world production had fallen from 64% to 22% as Middle East nations ramped up their output from 1.1 MMB/D to 18.2 MMB/D.

The 1973 Arab Oil Embargo was a political and economic shock, and ever since the U.S. has paid close attention to the region. The 1990-91 Gulf War fought to eject Iran from Kuwait was arguably all about oil reserves, and the U.S. continues to maintain a large military presence in the area. Yergin’s book had the good fortune to be published in December 1990, just a month before the U.S. and its allies launched Desert Storm. There is an eight episode documentary accompanying Yergin’s book that can be found on Youtube. It was shown on PBS in 1992-93, a couple of years after the book’s publication, and provides interviews with many of the oil executives and government officials involved at that time. One U.S. oil CEO had expected public opinion to demand less reliance on imported energy following 1973, and the second oil shock in 1979 after the Iranian revolution. But diversity of supply lessened OPEC’s power, and the Gulf War showed that Middle Eastern oil reserves couldn’t be seized by an unfriendly power.

Nonetheless, I found that reliving those events through Yergin’s book and documentary provoked feelings of outrage, and a wish that we never again find ourselves so vulnerable to others.

And guess what? American Energy Independence, for generations no more than an aspirational state, is clearly now in America’s future. It has multiple definitions – the Energy Information Agency (EIA) defines this as BTU independent, which means that we are a net exporter of energy in all its forms once they’re converted to their energy-equivalent, BTU content. The EIA’s Annual Energy Outlook 2017 projects that we shall achieve BTU-independence within the next decade. We recently achieved Natural Gas independence, as exports began exceeding imports over the past twelve months. Shipments of Liquified Natural Gas are set to rise substantially in coming years as new liquefaction plants become operational. We’ve long been a net exporter of coal.

Although BTU-independence is the most complete measure of our reliance on others for energy, most casual observers think simply in terms of oil independence, especially given the contemporary history recounted by Daniel Yergin. Photos of drivers sitting in gas lines remain an emotive image. The EIA makes a Reference Case forecast (its Base Case) but includes other less likely but still plausible scenarios. Their central expectation is for the U.S. to remain a net importer of petroleum products (defined as crude oil, refined products and natural gas liquids), albeit at a steadily diminishing rate, falling by two thirds within a decade.

But if crude prices rise higher than they expect, or improvements in the technology driving shale oil and gas output surprise to the upside, the U.S. could become a substantial net exporter.  OPEC long ago lost its ability to call the shots and in recent years their inability to set prices has been amply demonstrated. This is the enormity of the Shale Revolution. Its impact is far more than simply economic, although in that respect it’s already substantial. Its geopolitical effects will continue to reverberate through different countries’ needs for energy security. U.S. policy in the Middle East will reflect a reduced reliance on the region’s major export, something Americans will overwhelmingly welcome.

In a recent interview on the Shale Revolution, Yergin cited the sanctions imposed on Iran as an example of shifting energy power. He asserted that without the growth in U.S. oil production, the removal of Iranian oil supplies from the market would have been unworkable. Yergin has found that in discussions with foreign decision makers across Europe and Asia, there is a recognition that America’s role in the world is changing, in part because of improved security around energy supplies.

Today we’re seeing an alignment of resources, technology and public policy that together are bringing a seemingly Utopian vision closer to reality. Energy infrastructure is growing as it adapts to increased production that is supplying new markets. It may have taken half a century, but the dynamism of American capitalism is denying the ability of foreign despots or hostile governments to inflict substantial economic harm through manipulating energy exports.

 

Kinder Morgan (KMI) reported earnings last week, including a long expected dividend hike and a pleasantly surprising stock buyback. In many ways the stock performance and corporate finance moves of KMI reflect the Master Limited Partnership (MLP) sector as a whole.

Pre-Shale Revolution, Kinder Morgan Partners (KMP) had rewarded investors with steady distribution growth and modest (for their size) investments in new projects. Their investor presentation included a slide labelled “Promises Made, Promises Kept” with a table showing these consistently higher payouts.

Not all companies make old investor presentations available on their website – since it allows users to compare statements across years, it can be embarrassing. To KMI’s credit, they do. Consequently, we’re able to delve back several years and recall the world MLPs used to inhabit. This was a time of attractive, stable distributions with modest growth and an occasional need for growth capital. The Shale Revolution was not widely regarded as the energy sector game changer it became. Wealthy U.S. investors tolerant of K-1s liked the mostly tax-deferred distributions. MLPs were an income-generating asset class.

KMP, which was at the time the main operating entity, noted that from 1997 to 2011 it had invested $24BN in new projects and acquisitions. As was the norm, most of that growth had been financed by issuing debt and equity, since KMP paid out most of its Distributable Cash Flow (DCF) in distributions. Over the next two and a half years as infrastructure demand grew, they invested $20BN in growth projects & acquisitions for a total of $44BN over 17 years. The chart below on the left includes $2.3B of organic capex budgeted for 2H14 to total 46.5B by YE2014.

By mid 2014 KMI had concluded that the MLP investor base was too small to finance its growth. The 2014 presentation heralding the combination of KMI with KMP to create one integrated entity identified $17BN of organic growth projects over the next five years. Since 1997, $20BN of the $44BN had been invested in greenfield & expansion projects, with the balance being acquisitions. So the $17BN five year projected figure was analogous to the $20BN from the prior 17 years, since future acquisitions (the other source of growth) are generally very hard to forecast.

This is how the Shale Revolution manifested itself to big energy infrastructure companies. There was suddenly the need for lots more investment in attractive assets to meet new flows of hydrocarbons. But MLP investors weren’t big enough to provide the capital. KMI concluded this as the yield on their KMP units edged up, driven higher in order to attract the equity capital that their regular secondary offerings demanded. The 2014 KMI/KMP combination was intended to provide cheaper financing.

MLPs exist because of the tax code. Owning pipelines (or MLPs for that matter; see Some MLP Investors Get Taxed Twice) in a C-corp structure makes them taxable at the entity level, whereas MLPs largely don’t pay tax. But the universe of eligible MLP investors is limited to U.S. taxable K-1 tolerant investors, a small segment of all the global institutions who buy U.S. equities. As KMI found, if you need $Billions every year, MLP investors will start charging you more. Although folding KMP’s assets into KMI might have been expected to make them taxable, KMI’s clever advisers structured the deal to not be taxable for many years (see The Tax Story Behind Kinder Morgan’s Big Transaction). KMI could now fund its growth plans from the global equity market, not just MLP investors.

Their big mistake was to continue to think and act like an MLP. So they still planned to pay out most of their free cash flow in dividends, concurrently issuing new equity to get back most of it for growth. But corporations on average pay out a third of their profits in dividends, not 100%. Generating $4.5BN in DCF, paying $4BN in dividends and raising $2-3BN in equity looks a bit odd, albeit attractive to equity underwriters.  So the market priced KMI accordingly, driving up its yield. As it rose above 10% the idea of handing cash earned from existing assets out and getting it back to invest in new assets looked increasingly absurd, so they cut the distribution.

Notice that all of these issues were corporate finance ones. They all related to the liability side of KMI’s balance sheet. It was all about how best to finance future assets. The collapse in crude oil in 2015 affected KMI only modestly, because their cashflows are overwhelmingly from natural gas. Assets were mostly performing as expected, but their mis-steps were a combination of financing strategy and amount of growth. They certainly had the choice to cut their backlog of expansion projects, which would have lowered their need for new financing. But they chose as they did, and the 75% dividend cut created enough cash to eliminate the need for external funding. Had they opted for less growth they would have been able to maintain their original payout.

The growth backlog is declining as some projects (notably the $6BN North East Direct project, which was to improve natural gas distribution in New England) were cancelled and others completed. The excess cash is being used to reduce debt and starting in 2018 will be returned through higher dividends and a buyback. Other big MLPs merged their GP and MLP like KMI, reduced growth plans or did both. Leverage rose because new assets are built and financed before they generate EBITDA. As those projects are put into service, leverage is coming down.

Price history will show that KMI and the MLP sector endured a terrible operating environment during the 2015 crash in crude oil. Most investors even today regard the worst bear market in the sector’s history (see The 2015 MLP Crash; Why and What’s Next) as an oil-induced fall in operating results. The reality for KMI was that growth plans driven by the Shale Revolution exceeded the financing capacity of a specialized investor base. This is pretty much the case for midstream in general. It’s not obvious from a price chart, but if you followed developments real time it’s the real story.

We are invested in KMI

The shift from natural gas importer to exporter has occurred in the U.S. over a remarkably short period of time. We’ve periodically written about this (see U.S. Natural Gas Exports Taking Off and The Global Trade in Natural Gas). Only a few years ago Cheniere Energy (LNG) was investing in facilities to import Liquified Natural Gas (LNG), anticipating that the U.S. would need to rely on foreign suppliers such as Australia and Qatar. The Shale Revolution changed all that, and the conversion of planned regasification plants to liquefaction began.

The story of how this shift occurred is only complete when the role of Cheniere’s founder Charif Souki is included. Greg Zuckerman’s wonderfully absorbing 2013 book, The Frackers paints colorful portraits of several key protagonists, and Souki is among them.

A Lebanese immigrant to the U.S., Souki’s early career was with a small U.S. investment bank where he raised  money for deals in the Middle East, relying initially on his father’s contacts in the region. He was quite successful but eventually became tired of the deal making and travel. For several years he and his family lived in Aspen where he ran a restaurant. The relaxed lifestyle was a welcome change, and he enjoyed the regular visits of stars such as Jack Nicholson and Michael Douglas. However, the restaurant business wasn’t lucrative and eventually with his savings low he decided to shift directions again.

Given this background, Charif Souki was an unlikely energy pioneer. However, he applied his deal-making skills to the energy business and eventually wound up running tiny E&P company Cheniere Energy. The best part of the coverage of Souki in The Frackers describes how he convinced other investors to back him in developing LNG import facilities, only to subsequently have to raise more capital to convert them for export. It must have taken all his sales and deal-making skills to follow up one compelling vision with another, but he did.

Having brought Cheniere to the point at which it could start exports, Souki was forced out of the company by Carl Icahn. Souki’s substantial risk appetite had eventually paid off, but by then his shareholders were looking for rather less excitement. With $BNs in capital invested and contracts lasting 20+ years, the owners were looking for steady, reliable progress to realizing promised returns. Charif Souki was not that type of corporate leader.

I was reminded of all this the other day when perusing company presentations from a recent Energy Information Administration (EIA) conference. This year U.S. LNG exports at times have exceeded imports, driven in no small part by Cheniere. EIA projections through 2040 show the U.S. quickly becoming a substantial exporter.

Much of the shift to U.S. exports is well known to those who follow the industry closely. What’s less appreciated is how Cheniere is aligning itself with Federal policy. The President clearly likes to promote America when he travels, and be associated with deals. On his recent trip to Poland he was pushing LNG exports. There’s no doubting the energy security benefits across Europe from diversifying their supplies of natural gas so as to be less reliant on Gazprom. Energy exports and armaments will be part of the dialogue in virtually every Presidential trip abroad, as U.S. foreign policy promotes buying energy from a stable democracy and (for NATO members) spending more on their own defense.

But Cheniere also understands the importance of domestic politics, as this slide shows. What could resonate more effectively with the White House than exporting domestically produced energy security around the world? Cheniere isn’t the only company to understand that they’re in the sweet spot of alignment between corporate profitability and public policy objectives.

We are invested in Cheniere Energy (LNG)