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Last week’s blog post (Williams Satisfies Two Masters) highlighted the different views of cash payouts by the MLP investors who hold Williams Partners (WPZ) and the C-corp investors who hold Williams Companies (WMB), the General Partner of WPZ. WPZ investors value regular payouts whereas WMB investors are driven by total returns. WMB neatly gave both types of investor what they desired by diverting WMB dividends to buy new WPZ units which provided cash to fund WPZ’s capex program, and thereby eliminated the risk to WPZ’s distribution. One of the powerful features of the GP/MLP structure is that is allows a business to access different classes of investors who can have different objectives. As their appetite to provide capital fluctuates, the GP/MLP can access the more willing investor class.

Continuing this theme, Energy Transfer similarly found a way to make everyone happy with the same set of assets.  CEO Kelcy Warren is masterful at moving cashflows and businesses around to find value. Aligning your interests with Kelcy Warren works most of the time, even if he is occasionally ethically challenged (see Is Energy Transfer Quietly Fleecing Its Investors?).

On their recent earnings call, Energy Transfer Equity (ETE) generously announced that it would waive $720MM of Incentive Distribution Rights (IDRs) due from Energy Transfer Partners (ETP) to ETE over the next 6 quarters.  IDRs are the payments an MLP makes to its GP and are somewhat analogous to the incentive fees a hedge fund manager earns from his hedge fund. ETP traded up following the announcement of this largesse, and ETE traded down.  On the surface this is a straight transfer of value from ETE to ETP, a movement of cashflow from one pocket to the other. It’s a zero-sum transaction.

The ostensible reason is to support ETP’s stock price which will make it easier to sell new units of ETP. On the previous earnings call, Kelcy said: “In order to support ETP with its cost of equity capital in light of ETP’s current common unit price, ETE has recently advised ETP that ETE intends to waive its rights to receive incentive distributions, with respect to ETP’s 2016 issuances of common units… whether pursuant to the ATM or other offerings of common units, through fourth-quarter 2017 distributions. As these potential IDR waivers have not been approved by the ETE board, ETE is not formally bound to these proposed IDR waivers. This reinforces ETE’s commitment to support ETP.”  On the same call, Kelcy noted that, “ETE will do what it needs to do to support ETP”

ETP rose 10% on the day of the announcement.

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Although the conference call made it sound like an altruistic move by ETE, the relevant SEC filing noted that in exchange for these IDR waivers ETP was granting ETE new Class J units which would transfer $1.8BN of ETP’s depreciation, depletion and amortization (“DD&A”) to ETE over a period of three years (2016-18). Both ETP and ETE are partnerships issuing K-1s, so the proportional share of depreciation runs through each investor’s tax return. ETP investors will in aggregate have $1.8BN less in tax-deductible depreciation expense, approximately $3.44 per unit (there are 524MM ETP units outstanding). Assuming a 45% marginal tax rate (K-1 tolerant MLP investors are usually in the top rate) the taxable ETP investor is $1.55 per unit worse off. The IDR waivers work out to be worth $1.37 pre-tax per unit. So it’s at best a wash.

Prior statements from ETE include an assertion that ETE would not suffer any reduction in cashflows from ETP, and on the most recent conference call, Kelcy confirmed that there would not be additional IDR waivers applied to new equity raised at ETP. The IDR forgiveness is not equally spread over six quarters but is modestly back-ended. Therefore, we deduce that ETP will issue additional equity which will pay IDRs to make up for the shortfall from this IDR waiver. The rise in ETP’s stock price that followed this announcement makes it a little easier to issue equity. It also shows that ETP is valued, like other MLPs, on a pre-tax basis.

While MLP investors are drawn to the sector because of the tax-deferral that depreciation charges afford, few calculate their effective after-tax return on each individual security. They just send the K-1s to their accountant, who grumbles while charging a bit more, and the investor winds up with a lower tax bill. Figuring out which MLPs one holds are the most tax-effective is beyond most investors’ interest or ability. After-tax returns are notoriously quixotic and vary based on an individual’s tax situation. ETE management has insightfully spotted this. For this reason, most investment analysis relies on pre-tax returns. And sure enough, Barron’s quoted four analysts who gushed about the IDR waiver while ignoring the loss of tax shield (see Energy Transfer Partners Gets Fee Break from Parent, Shares Rise).

Kelcy has figured out that if investors don’t value something that highly you might as well give it to someone else. ETE investors (of which Kelcy is 18%) value the tax shield more accurately, which is clear since ETP’s stock rose even though the after-tax outcome for ETP investors didn’t add any value. Meanwhile, not only does the swap of tax shield for IDR waivers leave ETE investors better off after tax, but ETP can now issue new equity more easily, which will throw off additional IDRs for ETE indefinitely. The IDR waiver is expected to be $130M in 4Q17 after which it expires.  Starting in 2018 ETE will receive $520M more in IDRs each year for its “support” in which it gave up no cash flows and received $810M of value in DD&A units. Those Energy Transfer people are pretty clever.

We are invested in ETE and WMB

Just so it doesn’t seem as if we only pick on Energy Transfer, here’s a link to a recent TV spot on hedge funds.

Williams Satisfies Two Masters

Master Limited Partnership (MLPs) have been reporting earnings over the past couple of weeks. They were largely as expected with several names providing modest positive surprises. There were also some other interesting announcements – notably the sale by Energy Transfer Partners (ETP) and Sunoco Logistics (SXL) of part of their interest in the Bakken Pipeline Project to Enbridge Energy Partners (EEP) and Marathon Petroleum (MPC).

We calculate that ETP and SXL collectively invested $2BN developing this asset and have received $2BN for a partial interest, leaving them with a significant economic stake for minimal cash outlay. In addition, they removed competitor project Sandpiper by bringing its sponsors into their project and MPC’s refineries will be an important customer which could provide an uplift to volumes.  The value of the assets and backlog of the Energy Transfer Family is why we’re invested for now in ETP and SXL’s General Partner (GP), Energy Transfer Equity (ETE). This is in spite of misgivings about management who remain unapologetic about acting in their own self interest (see Will Energy Transfer Act With Integrity?). On this topic we salute friend Ethan Bellamy, R.W. Baird’s Senior Analyst covering MLPs, for shunning the usual, sycophantic “great quarter guys” posture of most analysts and asking CEO Kelcy Warren a direct question on his crooked converts.

But our focus this week is on Williams Companies (WMB). As they warned before the vote on their ill-fated merger with ETE, a dividend cut was coming and was duly announced this week. In the meantime, a failed effort to fire CEO Alan Armstrong resulted in six of thirteen board members resigning.

Dividend cuts usually reflect strategic mis-steps by management, and although WMB controls a unique asset in Transco (an extensive pipeline network covering much of the eastern U.S.) their stock has lagged the Alerian Index substantially over the past two years. CEO Armstrong might argue that the influence of activists led by Keith Meister (an investor whose long term advice is of dubious value, as we wrote in  The Corvex Discount) forced poor strategic decisions. The pending sale to ETE limited WMB’s ability to make any other moves, such as raising capital, until it was resolved.

But in this case WMB is using the cash saved from its reduced dividend to fund its growth capex, most of which is going to expand its Transco asset at attractive multiples. Although WMB cut its dividend by 70%, its MLP Williams Partners (WPZ) maintained theirs and both securities rose on the news. It was a perfect illustration of  the divergent views of dividends. WMB investors are total-return oriented and cheered the redirection of cash into high-return projects. WPZ investors just want the cash. Both classes of investors are getting what they want.

It reflects a different approach to the Sponsor/MLP model. Traditionally, the sponsor develops the assets and then sells them to its MLP through a “dropdown” transaction. The MLP raises capital through a secondary offering of equity (usually supplemented with debt) and uses the cash raised to pay its sponsor for the asset.

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This model broke down last year as MLP yields rose to levels that made equity financing prohibitive. And yet, many attractive investment opportunities remained. It illustrates that the problem with midstream MLPs last year was not poor operating performance but a need for growth capital in excess of traditional investors’ desire to provide it (see The 2015 MLP Crash; Why and What’s Next).

Prior to the WMB dividend cut, WPZ yielded 9.7%, representing an expensive cost of equity capital. The 70% cut in WMB’s dividend will save $1.3BN annually. WMB expects to invest $1.7BN through the end of 2017 in new WPZ units. WPZ will use this cash to fund its capex, thereby eliminating its need to issue equity to the public and also taking pressure off its distribution.

WMB can in the future sell the WPZ units it will be acquiring through the next five quarters when the market environment is better and yields are lower. It’s an elegant way to provide WMB C-corp investors what they want (invested capital in high return projects) and WPZ investors what they want (stable distributions under any and all circumstances). Because the two classes of investors have different objectives, there are different times to access them for capital. Today the C-corp investor is more receptive, whereas MLP investors are setting a higher price. In time the cycle will shift, and the MLP investor will be a more eager capital provider, at which time WMB may sell its WPZ units. Crucially, the Incentive Distribution Rights (IDRs), under which WMB earns 50% of WPZ’s incremental Distributable Cash Flow (DCF) will remain with WMB even after the WPZ units are sold. It’s like a hedge fund manager investing his own cash in his hedge fund when investors are hard to find but opportunities attractive, and later on replacing his capital at a profit with outside investors’ money which will pay the ubiquitous “2 & 20”.

This is why it’s better to invest in MLP GPs.

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We are invested in ETE and WMB

More on Solar

We received quite a few comments on our August newsletter (see Why Electric Cars Are Good for Fossil Fuels). We see solar-derived electricity generation growing at a high rate, but maintain that electric cars will for the foreseeable future consume electricity that is largely derived by burning natural gas and coal.

There are solar bulls who forecast that the sun will provide a substantial portion of our electricity in less than a generation (see Ray Kurzweil: Here’s Why Solar Will Dominate Energy Within 12 Years). Mr. Kurzweil’s Wikipedia page lists him as a computer scientist, inventor and futurist. He works for Google, so is a seriously smart guy.

So we won’t take on Mr. Kurzweil’s forecast directly; I’m personally a late adopter on most new things and on solar domination well, I’m just not quite there yet. But an important challenge for solar is that U.S. electricity consumption is barely growing, rising at 0.5% annually since 2000 according to the Energy Information Administration’s Annual Energy Outlook 2016. So to be significant quickly, solar will have to gain market share from traditional sources of electricity generation – and it is expected to gain at the expense of coal (as is natural gas). But to become the dominant source of electricity it will have to undercut many power stations that still have years of useful life ahead of them.

Moreover (as my partner Henry so insightfully noted), to do so they’ll need to deliver electricity not simply cheaper than the fully-loaded cost of a power plant but below its marginal cost. A nuclear power plant involves a high up-front cost to construct. Thereafter, its operating costs are the threshold for any new, competing source of electricity. As in micro-economics, once your fixed costs are spent, as long as you cover your variable costs you’ll keep producing widgets (or Megawatts). Power plants last for decades, so the openings for solar even if competitively priced will occur very slowly as less efficient plants are retired.

Furthermore, utilities and municipalities account for two thirds of U.S. gas transport capacity (pipelines) and sign long-dated volume & price commitments, making a quick switch ever more cost-prohibitive.  Replacing retired coal capacity is how natural gas is making inroads into coal (although expensive environmental regulations are hastening the process). For these reasons and a lot of others specific to the intricacies of the electric utility sector (including load balancing and regulations), we think solar will grow and yet fail to be dominant for decades, similar to all past transformative energy technologies.

Earnings season is here, and with it the quarterly ritual of the earnings conference call. Quite a few MLPs have declared their distributions, and of the 32 that we’ve seen so far none have cut while half have announced increases. Those we care about include Western Gas Equity Partners (WGP), which announced a year-on-year increase of 19.2%. Its MLP Western Gas Partners grew at 10.7% year-on-year, illustrating the faster growth enjoyed by General Partners. Similarly, EQT GP Holdings and EQT Midstream, increased their 2Q16 distributions 63% and 22% respectively over 2Q15. Magellan Midstream (MMP) grew at 10.8% year-on-year, while Crestwood Equity Partners (CEQP) was flat after cutting its distribution in April (see Crestwood Delevers and Soars). CEQP still yields over 11%.

Kinder Morgan (KMI), no longer a Master Limited Partnership (MLP) but nonetheless a bellwether of the sector, reported a solid quarter and maintained its dividend (slashed by 75% in December) unchanged. KMI is big enough that their fortunes are somewhat reflective of the overall energy infrastructure industry. Chairman Rich Kinder can scarcely have had a wilder ride than the last three years. In January 2014, frustrated by the weakness in KMI’s stock price in the face of relentless criticism from a small research firm, Kinder famously said, “You sell. I’ll buy. And we see who comes out best in the long run.”

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Kinder no doubt believes the long run is longer than the time since he spoke those words, because KMI is still substantially lower than it was back then. Kinder was still bullish at the top, and his antagonist remained bearish at the bottom. At least they both have conviction. Like other MLPs, Kinder Morgan identified growth opportunities beyond the appetite of traditional MLP equity investors to provide financing. In 2013 MLPs were raising more in equity capital than they were paying out in distributions (see The 2015 MLP Crash; Why and What’s Next). The Shale Revolution had created the need for more infrastructure, but it still strained their traditional financing model almost to breaking point. Kinder of course abandoned the MLP model altogether and became a conventional corporation (a “C-corp”), which made their stock available to any global investor and not just the limited pool of U.S. taxable, K-1 tolerant buyers. For the rest of the MLP sector, new mutual fund and ETF buyers provided an additional source of equity capital for a time, but falling prices caused some of them to exit. Every MLP investor by now knows how 2015 ended. KMI hoped to maintain the MLP distribution payout model of returning approximately 100% of Distributable Cash Flow (DCF) to investors. Finally, with the double-digit yield on their stock communicating a complete absence of gratitude for this largesse, they accepted the inevitable and slashed the dividend so as to delever their balance sheet (see Kinder Shows The MLP Model is Changing).

Which brings us to the most recent earnings call. Successful, big companies don’t shift strategy every quarter, even if sell-side analysts desire more “market-responsive” (i.e. fickle) planning. KMI had long argued that a Debt/EBITDA ratio of 5.5-6.0X was appropriate given their diversified business. The strategy shift triggered by the dividend cut in December was accompanied by a new, relentless focus on bringing this leverage ratio down to 5.0X. The cash saved by reducing the dividend was earmarked for paying down debt and financing growth projects, resulting in a less levered, self-financing KMI.

December 2015 to July 2016 is scarcely the long run by most standards. Nonetheless, analysts on the recent call were heard asking why KMI couldn’t finance some of its backlog of growth projects by issuing debt. Their $13BN backlog has a capex/EBITDA multiple of 6.5X, and is currently financed fully with internally generated cash (i.e. equity). This is down from 7.5X at their Analyst Day earlier this year, the result of “high-grading” their backlog (i.e. dropping the less attractive ones).  With a 15% unlevered after-tax return target on projects and a borrowing costs in the low single digits one can begin to see the appeal of debt financed growth.

Two quarters ago, sell-side analyst questions revolved around the speed at which KMI could reduce its leverage. Today, they’re being asked why they don’t increase leverage. One can hear the sighs of exasperation in the management team as they respond to the shifted goalposts such questions represent. It’s why running a private company can be more attractive – in fact, we often noted last year that if MLPs were unlisted and investors had to rely fully on financial statements in their evaluations, they would have concluded that not a great deal had changed. But this rapid shift in sentiment is what creates the opportunities for those that are able to keep their eye on the ball. Happily, Barron’s is shifting gears rather more slowly, with their first cautiously positive piece on MLPs in recent memory (see MLPs: Is It Safe to Dive Back Into the Pool Yet?). Skepticism is good.

We are invested in CEQP, KMI, MMP and WGP

The expression “like sending coals to Newcastle” can be traced back to the 17^th century, reflecting the insight that whatever else Newcastle needed in those days did not include coal. This windswept port on the North Sea was conveniently located near some of the biggest coalfields of northern England. During its heyday, American trader Timothy Dexter defied common sense and sent a shipment of coal to Newcastle, causing anticipation of a substantial loss. However, perhaps by luck he had the good fortune for his cargo to arrive during a miners strike, thereby profiting from unusual and temporary demand. Coal exports have long since ceased along with local coal production. Today’s Newcastle possesses little of note beyond an English football stadium with capacity well in excess of their local team’s ability (they were just relegated from the Premier League). Meanwhile, Newcastle in the Australian state of New South Wales has become the world’s most prolific coal exporting port.

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LNG to the UAE doesn’t quite roll off the tongue as easily as Coals to Newcastle, but it might be a modern-day equivalent. The Middle East has 2.8 quadrillion cubic feet of proved natural gas reserves, enough to meet current global demand for 23 years. OPEC reports that the United Arab Emirates (UAE) holds around 10% of this. And yet, earlier this year the Energy Atlantic LNG tanker unloaded 3.38 BCF (Billion Cubic Feet) of natural gas at the port of Jebel Ali, near Dubai, following an almost seven week journey from the Sabine Pass LNG terminal in Louisiana.

Somehow the power of economics (see Why the Shale Revolution Could Only Happen in America) has overwhelmed the logic of geographic proximity to make such a delivery commercially reasonable in spite of abundant local resources. To show this was no fluke, more recently the Creole Spirit unloaded a similar amount in Kuwait, also sourced from Sabine Pass. The region hasn’t developed sufficient energy infrastructure to properly exploit its resource domestically.

The story of America’s Shale Revolution was built on the single-minded pursuit of unconventional fracking technology by many independent exploration and production (E&P) companies as well as some extraordinary chutzpah by a few. The Frackers by Greg Zuckerman memorably tells the story of some of them. Cheniere Energy (LNG) under then-President Charif Souki was once intent on importing LNG into the U.S. to take advantage of relatively high domestic prices. Cooling natural gas to a near-liquid state (at -260° F) so it can be moved in a condensed form by ship requires a substantial investment (i.e. US$BNs) to create such a facility, as does the construction of a regasification plant on the receiving end. Souki’s career wasn’t obviously suited to leading Cheniere on this journey, having been primarily focused on raising money for banking clients in his native Lebanon and elsewhere in the Middle East. His past also included a stint as restaurant owner of Mezzaluna, the now infamous Los Angeles eatery where Nicole Simpson ate her last meal on June 12, 1994 before being slain by O.J. Simpson (ahem…allegedly).

Undaunted by the absence of any relevant experience, as President of Cheniere Souki set out to use his former banking ties to finance their new business. The Shale Revolution led to a collapse in domestic natural gas prices and turned the economics upside down, causing Cheniere to turn from prospective LNG importer to exporter.

The facility that can regassify LNG for normal use is not the same one that can liquify it for long distance transport. Converting an LNG import facility to an export one is not the same as reversing a pipeline, and many more $Billions were required for Cheniere to be ready for business. Just as export operations began, Souki was pushed out by its board of directors which included Carl Icahn. The boss’s substantial risk appetite was by now well known, but his latest plan to add a gas trading business was a risk too far for investors who could finally see actual cashflows on the horizon. Souki’s compensation over the years had matched his ego, but recognizing that his risk appetite didn’t match ours we have never invested in Cheniere.

The Sabine Pass facility began exporting late last year and is eventually expected to handle 3.8BCF per day. Some of its supply travels from the Marcellus shale in Pennsylvania along the Transco pipeline network owned by Williams Companies (WMB), in which we are invested. A few weeks ago I had the opportunity to be presenting in Laceyville, Pennsylvania to a group that included landowners receiving royalty checks from the production of natural gas under their property. As we noted last week, few countries assign mineral rights to the owner of the land beneath which they sit.

For just a moment, step away from the prosaic question of the market’s near term direction and consider this: an Egyptian-born Lebanese former restaurant owner raised $Billions to export liquefied natural gas over 11,000 miles to a region of the world whose wealth is totally reliant on hydrocarbons. It couldn’t have happened anywhere else, except America.

We are invested in WMB

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).

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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

The Brexit vote is now two weeks behind us and I still watch developments with jaw agape. Rarely in history has the consequence of a popular vote led so directly to a recession. The IMF has forecast that the UK economy will shrink by 1.5% through 2019 if they agree to a Norway-style EU access (i.e. similar EU budget obligations, lack of immigration controls and submission to EU regulations but with no ability to influence them, not exactly what Brexiteers voted for). Or, if EU access conforms to the World Trade Organization (WTO) tariff framework, the UK economy will shrink by 4.5%. Leading Brexit campaigners such as Boris Johnson and Nigel Farage have exited stage left now that their goals have been achieved. Brexit voters gamely advise that everything will be OK, while decision makers prepare for a recession. Fewer UK jobs will likely reduce immigration anyway, although this is hardly the best means of achieving that goal. And yet, in theory the entire non-UK EU population of almost 450 million people could have relocated to the UK, at which point the country would have resembled a Piccadilly line tube train at 5pm. Free movement of people, a core, inviolable principle of the EU, is absurd.

Nonetheless, Brexit was not a carefully considered response but a visceral reaction with far-reaching and poorly considered consequences. Churchill  once said, “The best argument against democracy is a five-minute conversation with the average voter.” Brexit leaders have led their followers to the cliff and then retired to the pub for a drink while they watch the leaderless deal with the aftermath.

One result is that bond yields globally have fallen to hitherto unimaginable levels. The Barclays Aggregate Index is +6% YTD, beating the S&P500. Regular readers will be familiar with our past illustration of the paltry returns available on bonds whereby we compare a barbell of stocks and cash with the ten year return on bonds. In our April newsletter we wrote about The MLP Risk Premium. With reasonable assumptions about MLP distribution growth rates and prevailing valuations in ten years, you could swap out your bond portfolio for as little as 10% in MLPs with the rest in cash while still achieving a bond-like return. MLP yields have fallen since we wrote that in April, but so have bond yields so the broad set of choices still favors almost anything over bonds but certainly still MLPs.

Federal Open Market Committee (FOMC) minutes released last week confirmed what we’ve long noted, that Janet Yellen will never miss an opportunity to avoid raising rates. Ignore their words and try considering this Fed’s actions as if they’d announced the solution to excessive debt was to keep rates low for a long time. The rhetoric doesn’t reflect such a strategy but their actions most assuredly do. Waiting for rates high enough to justify an investment requires substantial patience, during which time investors are steadily pursuing equity-type risk with its better return prospects.

Tallgrass Energy GP (TEGP) raised its quarterly distribution by 16.7% quarter-on-quarter and 84.2% year-on-year from its pro-forma 2Q15 level. Not every MLP or GP is raising its distribution by any means, but less than six months ago such would have been unthinkable. Meanwhile, the Alerian MLP ETF (AMLP) reached a milestone of sorts, in that the recent recovery in MLPs has finally moved AMLP to where it once again has unrealized gains on its portfolio. As we noted in March (see Are You in the Wrong MLP Fund?) this is the point from which AMLP investors will now earn only 65% of any subsequent upside since the U.S. Treasury will take 35% through corporate tax. Indeed, the tax drag has already had an effect, since AMLP’s YTD performance through June 30 is +10.7% versus the Alerian Infrastructure Index +13.1%. Those AMLP investors who are bullish on the sector (which presumably includes all of them) will, if right, contribute modestly to Federal finances at the expense of their own investment results and reputation for careful analysis. AMLP is the refuge of those who stop at Pg 1 of a prospectus rather than examining Pg 23, Federal Income Taxation of the Fund. This is part of the reason why a more thoughtfully designed, non-taxable, RIC-compliant MLP fund (which we run) has done very well.

We are invested in TEGP.

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

Last week Wood Mackenzie released a report estimating that oil and gas companies will spend $1TN less on finding and developing new reserves through 2020 than was expected to be the case before the 2014-16 oil price collapse. 2016 reductions in capex have been estimated at $300-400BN, but this is the first credible figure we’ve seen over a longer period of time. It’s likely to be followed by substantial changes in the crude oil market that will benefit U.S. shale producers.

To see why this is the case, consider how the risk profile of a conventional new crude oil project has shifted. Whether it’s offshore, or Canadian tar sands, these plays require substantial upfront capital investment with a payoff over many years. If it’ll take you five years or more to extract and sell enough crude oil to earn an acceptable IRR, you are simply long crude oil. Exploration and production companies (E&P) routinely hedge only for a couple of years out, because that’s all that the liquidity of the futures market will reasonably allow. For example, Pioneer Natural Resources (PXD) shows 85% of this year’s crude production hedged but only 55% of next year’s. This is fairly typical.

The price collapse of last year, combined with the growth in U.S. shale extraction and enormous cut in capex, reveals the following calculus: evaluating a new conventional project requires assessing some probability of another price collapse to $30/BBL or lower during the life of the project. Prior large drops in oil, such as in 2007-8 or 2000 coincided with a recession and were the result of a drop in economic activity. While softening global growth bore some responsibility for the most recent drop, it was largely caused by supply increasing faster than demand.

So now imagine the difference in risk assessment facing an E&P company contemplating an investment in a new shale project versus a conventional one. Shale extraction is characterized by large numbers of individual wells completed relatively quickly with high and sharply declining production. Data from the Energy Information Agency shows that the cost of drilling a single well in any of the five most prolific U.S. shale regions has fallen to $6-7MM. Much has been written about declining production costs, which is why U.S. crude oil production only dropped from 9.5MMBD to around 8.5MMBD even while the rig count fell by 75% 2015-16. That increased efficiency includes better use of drilling rigs, so they’re not needed for as long to drill a well. The corresponding fall in costs has also shortened the time to break-even for shale drilling.

By contrast, in Canada the enormous upfront investment required in a tar sands project meant that production has continued to ramp up seemingly impervious to the price of oil. Steam-Assisted Gravity Drainage (SAGD) involves sinking pipes into the bitumen to heat it up for extraction. Shutting down production risks the pipes freezing, causing potential damage to the facility. So Canadian operators have continued production even at prices that fail to cover their operating costs because of the risk to their huge capital investment.

The consequence of a price collapse in the future looks entirely different to these two operators. The U.S. shale operator is nimble and can rely on hedging production because high initial production rates mean more oil is produced sooner. But the shale operator also knows he can respond to lower crude prices by stopping drilling. He has a short response time.

The tar sands operator has to make a long term forecast on crude oil that cannot be hedged. He has no way to mitigate his exposure to prices years out, and his scenario analysis now has to incorporate some possibility of a repeat of 2014-16. Moreover, the existence of shale oil production raises the risk of a future temporary collapse, precisely because the E&P companies whose collective activity might cause it can so easily respond and protect themselves.

The swing producer is not the lowest cost producer, but rather the producer whose time to break-even is shortest. The risk of a future big drop in oil is why $1TN in capex has been cut. The market has changed, and it favors the nimble producer who can exploit temporarily high prices and then drop back when prices do. We may have a permanently higher crude oil price over the long run, precisely because the risk of ruin dissuades the big projects whose supply would lower prices. Canada may never see another new tar sands project. The outlook for U.S. shale, with its constantly improving technology, falling break-evens and short time required to recover capital invested, looks very bright indeed.

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.

Last week was the annual Master Limited Partnership Association (MLPA) Conference, held in Orlando, Florida. Conferences held in the Sunshine State in June undoubtedly receive a discounted rate compared with January – perhaps some frugality was appropriate given last year’s sector performance. Many were happy simply to have survived the 2015 Crash with their businesses still intact. The Hyatt Regency is a vast facility, although within such a cavernous venue the 10-20% drop in attendance meant it was never crowded, reflective of MLPs remaining an out of favor sector. While there were certainly no signs of a bubble, I can personally attest to the high quality hors d’oeuvres and how they helped promote warm feelings among attendees at the end of each day. 

Although events revolve around the formal presentations made by MLP executives, far more useful is the opportunity for more intimate meetings with key individuals running our portfolio companies as well as comparing views with other industry professionals. While most MLPs were represented, a notable absence were Energy Transfer and Williams Companies (WMB). They no doubt concluded that questions would revolve around their contentious merger which has generated multiple lawsuits, and since there’s probably little they can say on the matter there was no point in being there. They were a subject in countless conversations though.

Energy Transfer CEO Kelcy Warren has drawn widespread opprobrium for the recent convertible preferred issue that dishonestly transfers wealth from Energy Transfer Equity (ETE) investors to management (see Is Energy Transfer Quietly Fleecing Its Investors?). WMB has already filed suit on the matter, although their interest in its resolution will drop once the bigger question of the proposed merger is concluded. But conference participants widely derided ETE’s newly granted securities as self-dealing, even fraudulent. It would seem likely that others will sue ETE over this issue if it’s not resolved by WMB. ETE’s ability to credibly engage other managements on possible combinations in the future has been damaged, perhaps irreparably. The question for Kelcy Warren is whether his legacy will include amassing great wealth in part by defrauding his investors. We monitor developments with interest.

One participant noted that there were more bankers in attendance than actual investors, no doubt reflective of the sharp drop in capital markets activity in recent months. M&A deals haven’t occurred in sufficient quantity to fill the gap in bankers’ fee income, as the common refrain about overly wide bid/asks on possible transactions was widely blamed. The same search for transactions attracted an abundance of lawyers, including fifteen from one firm.

In recent years the midstream sector responded to the Shale Revolution with sharply increased growth plans. Much of this was a logical reaction to the huge increase in domestic hydrocarbon production. However, several management teams noted that this put pressure on cashflows since projects must be financed before they generate any return. They attributed the 2015 collapse to this as well as a tendency to “just-in-time” finance, in that equity capital is raised only when actually needed rather than at the inception of a project. The downturn exposed balance sheets in a way that won’t soon be forgotten, and a more conservative approach to funding projects is likely to be the industry norm.

A panel discussion titled “Is the MLP Model Broken” predictably concluded it wasn’t, but a slide from Kevin McCarthy at Kayne Anderson (reproduced below) showed how far from home some underwriters had strayed, with 40% of IPOs since 2008 being non-midstream. Midstream is all we invest in, and most of the 40% non-midstream issues should never have been offered in the MLP structure. Their subsequent performance was a whopping 37% worse than midstream IPOs – examples include recently bankrupt Linn Energy (see Why Linn Energy Was the Wrong Kind of MLP).

The overall atmosphere was cautiously positive, in the same way that surviving a near-death experience makes one appreciate even the mundane. Churchill once noted there was nothing more exhilarating than to be shot at and missed. Such might accurately reflect the emotions of MLP investors following last year’s crash. Just being at an MLP conference provides welcome proof of one’s continued financial existence.

As mentioned, the smaller meetings with senior management of companies in which we’re invested were far more useful than the formal presentations in the enormous ballroom. EnLink Midstream (ENLC), Western Gas Equity Partners (WGP), Plains GP Holdings (PAGP), Crestwood Equity Partners (CEQP) and SemGroup (SEMG) were among those who provided helpful additional information as well as confirmation of their appropriateness in our investment portfolios. Although such interactions are governed by “Reg FD” to ensure all relevant information is fully disclosed to all investors at the same time, it’s still possible to draw insights about strategy with well-crafted, open-ended questions. Asking a CFO what element of their business is least appreciated by most investors can produce useful insights.

Over the past several months increasing concern has been voiced about the enforceability of gathering contracts by midstream MLPs on oil and gas drillers facing bankruptcy. On this question anecdotal feedback overwhelmingly supported the conclusion that hydrocarbon production not dispatched through its contracted gathering and processing infrastructure has few good options. No bankrupt E&P company will induce a new G&P provider to build new infrastructure following a contract dispute with its existing G&P firm. The midstream MLP in such cases holds the stronger negotiating hand. One banker reported to me that he had an MLP borrower with two E&P customers in bankruptcy and he wasn’t worried; even in bankruptcy they’d still need cashflow, and continuing production was the only plausible way to generate it.

The cautiously optimistic tone from a crowd largely chastened by last year’s crash reflected little complacency and a conviction to avoid some of the overly ambitious growth that occurred in the recent past. This should provide a solid foundation for returns in the future.

We are invested in CEQP, ENLC, ETE, PAGP, SEMG and WGP