Midstream Energy Infrastructure Archives - Page 67 of 75

The Limited Rights of Some MLP Investors

May 29, 2016/1 Comment/in Midstream Energy Infrastructure/by Simon Lack

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.

Tallgrass Energy is the Right Kind of MLP

May 22, 2016/2 Comments/in Midstream Energy Infrastructure/by Simon Lack

Tallgrass Energy is the Right Kind of MLP

If Linn Energy was the wrong kind of MLP (see last week’s blog), Tallgrass Energy is the right kind. They have an MLP, Tallgrass Energy Partners (TEP) and a publicly traded General Partner, Tallgrass Energy, GP (TEGP). It’ll come as little surprise to regular readers that we are invested in TEGP alongside CEO David Dehaemers because, as Willie Sutton knew, that’s where the money is. Dehaemers runs a great conference call, combining plain talk with a little levity, such as promising to finish a recent call in time for analysts to get their opinions from Jim Cramer’s Mad Money.

Last week Tallgrass held a webcast to discuss their Rockies Express natural gas pipeline (“REX”). The slide below is from that webcast. REX runs from Wyoming to West Virginia, from “Shale to Shining Shale” if nonetheless short of being completely transcontinental. TEP recently acquired a 25% interest in REX from privately-held Tallgrass Development. It’s a great asset, with the ability to connect to many population centers across the northern U.S. states it traverses. However, the recent abundance of natural gas in the north east U.S. out of the Marcellus and Utica shales has hindered the traditional west-east flow of gas from the Rockies, and had especially affected demand in the Zone 3 eastern section of the pipeline from Illinois.

The webcast provided a positive update on the contracting of capacity on REX. Last year Tallgrass implemented a pipeline reversal on Zone 3 to allow two-way flow on that part of the network. They anticipate extending this to the rest of REX in the years ahead. The increased capacity and flexibility create substantial optionality to meet future demand, and have brought improved visibility to the EBITDA REX is expected to generate. Consequently, TEP is guiding to 20% distribution growth. More interestingly for Dehaemers and other investors in the GP, TEGP is expecting to grow its cash distributions at twice the rate of TEP. Since TEGP’s entitled to half the additional Distributable Cash Flow generated by TEP, growth at TEP is magnified for TEGP, whose economic relationship with TEP resembles that of hedge fund manager to hedge fund. Tallgrass is midstream infrastructure operating a toll-type business model. Tallgrass is the right kind of MLP.

Is Irrational Exuberance Returning to MLPs?

Such a question seems premature by at least several years, and yet is prompted by the issuance last week by Credit Suisse of a 2X levered note linked to the Alerian Index. Its buyers must desire to make money in a hurry, a quest which invariably results in the opposite outcome.

At the risk of being a party pooper, below is a simulation of the performance AMJL would have delivered to its thrill seeking holder had he invested at the beginning of 2014. Here I’m unapologetically sexist; only a man would buy AMJL (see June 2014 newsletter How to Invest Like a Woman). The highs would have been high, but the lows would have been, well, low. AMJL’s creator is unburdened by the need to design products for which a long term holding period is preferable. Lots of products are sold that nonetheless are bad for you, including tobacco products, cocaine and non-traded REITs. Add enough warning labels and (with some exceptions) you can meet consumer demand. However, you are unlikely to find a CFA charterholder near AMJL because the CFA’s Integrity List includes “Place the client’s interests before your own”, a requirement inconveniently at odds with distributing securities whose holders, “…intend to actively monitor and manage their investments” (as noted in the 14 page section on Risk Factors).

If a non-financial company issued a security like AMJL, potential buyers would reasonably assume that the issuer’s objective was simply to raise money cheaply. Credit Suisse has the same objective, and yet as their brokers promote it some confused investors will assume Credit Suisse has their best interests at heart and will be persuaded that it is a good investment.

There are worse securities than AMJL to be sure. It is not in the league of non-traded REITs. But it is one whose proponents have fingers crossed while promoting, and will hopefully inflict less damage on clients than two similar ETN’s issued by UBS which collapsed far enough to trigger mandatory redemptions as recently as January (see the second section of this blog post from January). Standards in Finance are not yet unreasonably high.

We are invested in TEGP.

Why Linn Energy Was the Wrong Kind of MLP

May 15, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

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%.

Is Energy Transfer Quietly Fleecing its Investors?

May 10, 2016/3 Comments/in Midstream Energy Infrastructure/by Simon Lack

The Energy Transfer-Williams deal has been a rich source of material for this blog, as well as an important driver of MLP performance. Energy Transfer Equity (ETE) was creative in its pursuit of Williams Companies (WMB); as buyer’s remorse quickly set in they were equally creative in pulling all the levers at their disposal to force a renegotiation. As part of this effort to alter the terms of the deal, ETE has taken some steps that transfer wealth directly to ETE CEO Kelcy Warren and other insiders, at the expense of the rest of the ETE unitholders. Whether this was done to drag WMB back to the negotiating table will be clear if the steps are undone once the transaction is deemed to not close, or renegotiated. In other words, ETE management has engaged in blatant preferential self-dealing; we’re watching to see how it plays out. The SEC filing describing the offending security is here.

The original merger agreement consisted of WMB shareholders receiving 1.5274 shares of Energy Transfer Corp (ETC) per WMB share and $8.10 in cash. ETC shares were designed to be worth the same as ETE units, and were created so that WMB investors wouldn’t have to deal with the K-1s issued by ETE. On September 28, 2015 ETE valued the transaction at $43.50 per WMB share, based on where ETE had been trading just prior to the announcement.

The $8.10 per share in cash promised added up to $6.08BN, and ETE’s intention to finance this with debt steadily weighed on the stock price. As ETE fell, the value of the deal to WMB fell, and ETE management quickly concluded that they needed to renegotiate the terms. Whatever overtures were made in this regard evidently did not draw the desired response, so ETE dropped the gloves.

Suppose for a moment you committed to reinvest a portion of your future dividends back into the company you run; this show of confidence would be welcomed, and reinvested dividends typically buy shares at the current price when the dividends are received. The Duncan family has done this with Enterprise Products Partners (EPD), of which they own 34%. Or, suppose you felt your company’s stock was ludicrously cheap and worth buying; you’d get as many shares at today’s price as you were willing to pay for, today. NuStar’s chairman Bill Greehey continuously does so on the open market with MLP NuStar Energy LP (NS) and its General Partner NuStar GP Holdings (NSH).

It seems pretty simple: if you pay today you get today’s price, and if you pay in the future you get the future price. But on March 8, Kelcy Warren and a few insiders created for themselves a special security that allows them to be both senior in the capital structure to the common unitholders and to buy units of ETE in the future but at a price that’s roughly half of where it trades today.

To show how riskless this transaction is for them, the $6.56 price of ETE at which they can buy priced ETE at a yield of 17.37% (based on its 4Q15 $0.285 quarterly distribution). This is where ETE was trading in early March. Clearly, the market held serious doubts as to whether the distribution was secure. The convertible units ETE has issued require ETE insiders representing 31.5% of the company to invest future distributions in excess of $0.11 per share back into newly issued ETE units. There’s a wonderful circularity to this – if the 17.37% yield on ETE from March turns out to be prescient and future distributions to common unitholders are eliminated, the insiders don’t have to stump up cash to buy the extra ETE units. But if the 17.37% yield turns out to be a grossly pessimistic forecast, and distributions continue to be paid, the insiders will get to use the distributions paid to buy units at a price whose existence the subsequent payment of distributions has rendered ludicrously low.

Put another way, ETE has raised capital at the exorbitant rate of 17.37%, although that capital will only be available to them if they’re able to continue paying distributions, which would suggest they didn’t need it in the first place. If they are unable to keep paying, the capital won’t be there.

It’s a form of heads I win, tails you lose. Most investors in a stock that had lost 90% of its value (as was the case with ETE at that stage) would jump at such an opportunity.

But it gets better. The insiders who own this convertible security now have seniority, in that the $0.11 per unit “Preferred Distribution Amount” is paid to them “prior to any distribution on the Partnership’s common units”. So the new security is really a Convertible Preferred, not simply a Convertible which is what they’ve called it in the SEC filing. Kelcy and his friends have moved themselves up in the capital structure.

There’s even more though. The insiders get to invest their future distributions back into ETE at the knock-down price of $6.56, but even if those distributions are not paid they still get the additional units of ETE. The irony is that ETE only sunk to such a low price because of management’s poorly conceived merger proposal. They screwed up so badly they felt entitled to grant themselves additional units at the bargain basement price their actions had caused. To show just how scandalous this new security is, ETE could eliminate their distribution and yet Kelcy and his friends would still receive their $0.11 per unit Preferred Return in cash AND be entitled to 79 million new ETE units without having to pay for them. At today’s price this represents a transfer of wealth from the non-insiders to Kelcy and friends of over $1.3BN.

This opportunity was only offered to certain accredited investors. Kelcy Warren owns approximately 18% of the partnership. The recipients of this gift from the rest of ETE are essentially the senior management, notably Kelcy himself but also 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). It’d be interesting to hear any of these gentlemen justify their participation, and to reconcile it with their fiduciary obligation to other ETE unitholders.

You’d think this kind of egregious self-dealing would be illegal. ETE claims that they wanted to offer this opportunity to all the ETE unitholders but because of the merger agreement with WMB they were required to obtain WMB’s approval. Under the deal, each WMB share is worth 1.5274 shares of ETC (in effect, ETE), but because the convertible issue took place before closing the deal it had the effect of reducing ETE’s purchase price for WMB. The converts will increase the number of ETE units outstanding, thus diluting their value. It alters the terms of the transaction. WMB couldn’t possibly agree to this, and so they naturally withheld their approval. ETE went ahead with it anyway, claiming that WMB’s failure to approve the converts limited the offering to the select group of insiders noted above. But since WMB couldn’t reasonably be expected to approve what was in effect an 11% dilution in the value of the equity portion of the deal, their response wasn’t surprising.

We originally thought the converts were issued as part of an aggressive negotiation strategy intended to persuade WMB shareholders to vote against the deal or get WMB’s board to agree to altered deal terms. The $6BN cash payment has hung over both stock prices for months. And the SEC filing noted that the proceeds from the foregone distribution payments would be used to pay down debt incurred in conjunction with the WMB transaction. So you might reasonably assume that if the transaction fails to close, the converts won’t be needed and Kelcy Warren will remember his fiduciary obligation. He can cancel the issue.

However, ETE’s most recent earnings call made clear that these convertible units would remain regardless of the merger closing. The sell-side analysts as usual avoided any tough questions. But the biggest question, which wasn’t asked, was how Kelcy could justify such abuse of his fellow public ETE unitholders.

Equity investors in ETE are referred to as Limited Partners. But following the issuance of this new security they are no longer partners at all, but rather victims of self-dealing by management, owners of an inferior class of securities created by the insiders moving themselves up to a superior position with superior economics for no consideration.

It’s not too late for Kelcy to clarify this issue. On the list of CEOs who have performed as honorable stewards of investor capital, you will not find Kelcy Warren. He may be a billionaire, but he is no Warren Buffett. We hope ETE will revisit this abuse of their unitholders and restore their reputation for honest dealing by canceling the issue. Otherwise, why would anybody ever do business with them again?

We are invested in ETE, EPD, NSH and WMB

Quarterly Report Cards Provide Comfort

May 8, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

Quarterly Earnings

We’re approaching the time of year when report cards proclaiming, “what a joy your child is to have in my class” are dispatched with varying degrees of sincerity. Quarterly MLP earnings are the report cards of the industry, and a time when investors can similarly consider whether they are happy to have included PCD (Promised Cashflows Delivered, LP*) in their portfolios.

A couple of years ago Master Limited Partnerships (MLPs) used to be a reliably boring sector. The influx of new money from ETF and mutual fund investors quickly turned and fled when oil started declining (see The 2015 MLP Crash; Why and What’s Next) which caused MLPs to be exciting in a decidedly distasteful way.

However, operating results for midstream infrastructure businesses weren’t remotely as volatile as their stock prices, which increasingly supports our theory of last year’s collapse; it was a funds flow issue caused by recent investors following (and thereby accentuating) near term momentum. Most firms have released their quarterly operating results, and they were generally decent with some mild positive surprises. MLPs rarely release figures that are substantially off expectations.

TransCanada (TRP) reaffirmed 8-10% growth in its current C$2.26 dividend (yielding 4.4%). Targa Resources (TRGP) experienced some modest softening of margins in their natural gas Gathering and Processing (G&P) segment although volumes were overall as expected. Western Gas (WES) reported EBITDA 15% ahead of expectations due to sharply higher production by Anadarko (APC), their sponsor. This allowed the GP of WES, Western Gas Equity Partners (WGP), to grow its distribution 24% YoY, twice the rate of WES. It’s why the people who run MLPs don’t invest in MLPs, but instead put their money in the GPs that run them. Hedge fund managers make their money from payments they receive from the hedge funds they manage. So it is with MLP managers. As the chart shows, if you add up where MLP insiders invest their own money they prefer GPs by a factor of 22X.

EnLink Midstream Partners (ENLK) was slightly ahead of expectations and provides 1.09X distribution coverage. Its sponsor and biggest customer Devon Energy (DVN) raised its production guidance by 3% having previously announced moves to shore up its balance sheet (asset sales, secondary equity offering and sharply reduced 2016 capex). Credit enhancement moves by DVN are good for its MLP. ENLK’s GP, EnLink Midstream (ENLC) yields 7.3%.

Spectra Energy Partners (SEP) reported EBITDA that was 7% below expectations as mild winter weather reduced natural gas volumes. They are pressing on with Access Northeast which will enhance natural gas distribution and storage in New England if it is implemented. Kinder Morgan (KMI) recently cancelled their North East Direct project due to insufficient demand, so it’ll be interesting to see how Access plays out. SEP increased its distribution 8% YoY. Their GP Spectra Energy Corp (SE) yields 5.3%.

Energy Transfer-Williams

Energy Transfer Equity (ETE) CEO Kelcy Warren has tried everything to extract himself from his ill-advised pursuit of Williams Companies (WMB). His former CFO lobbied WMB shareholders to reject the deal; with dubious legality and no fiduciary compunction ETE issued preferential securities to management, diluting the deal’s value to WMB; they also slashed the anticipated synergies from the original $2BN figure.

Risk arb traders are not a group that normally draws much sympathy. They buy stock in companies that are being acquired and hedge the position by shorting the acquirer. They bet on deals closing as anticipated, which they usually do. Frequent modest profits are occasionally punctuated by expensive surprises. The chart below shows the price of WMB compared with the actual price implied by the terms of the ETE deal. The smaller the spread (or discount to deal terms), the more likely it is to close. The bigger the spread, the less fun risk arb traders are having. You might also think of it as representing the fluctuating stress imposed on involved traders as the odds of the deal closing oscillated. Even Bobby Axelrod (from Billions) would have been challenged to make money. It’s a curious set of circumstances when the suitor experiences such rapid regret (see Williams Stands Alone at the Altar) and that made it harder for some to assess likely outcomes.

Kelcy Warren recently said of the deal, “We can’t close. We don’t have a transaction that can close. So I want to be very clear, we can’t close this transaction.” Since the absence of an affirmative tax opinion is the basis for this conclusion, we can assume that such insight was arrived at only belatedly (after the other forms of avoidance described above had been used). They may still close on altered terms, although since the WMB board was previously divided on the topic it’s hard to imagine them coming together on less favorable terms given recent history. ETE’s tax counsel has certainly earned their fee.

We are invested in ENLC, ETE, KMI, SE, TRP, WGP and WMB.

*PCD is not a real company

Filling Up

April 30, 2016/1 Comment/in Midstream Energy Infrastructure/by Simon Lack

“Yes, but are the pipes full?”

This was the pointed and entirely reasonable question of one investor several weeks ago after hearing that the energy infrastructure sector offered compelling value. It cuts directly to the crux of the issue. You can discuss the sanctity of contracts, stability of cashflows, limited commodity exposure and yet the most fundamental metric about any toll-based business model is how much of its capacity is being used. If you own a bridge you care little about the price of cars but are happy to see heavy traffic passing through your tollbooths. While Master Limited Partnerships (MLPs) never claimed immunity to falling oil and gas prices, high utilization of their assets is unambiguously good.

It would be nice if there was a heat-map of all the pipelines in North America that showed their utilization with different colors. Sadly, no such scoreboard exists and so the view has to be assembled piece by piece. Earnings reports from individual MLPs provide a contemporaneous picture of utilization. Some first quarter reports have already been released and the signs are generally good. NuStar (NS) noted increasing demand for their Eagle Ford pipeline assets which was surprising given weakening output in that play. Noted shale driller Pioneer Natural Resources (PXD) reported higher than expected crude production with continued declining costs. Some of their horizontal wells extend over 10,000 feet laterally, improving productivity. They now expect production costs in 2016 of $9-11 per barrel of oil equivalent (BOE). In 1Q16 these costs were down 20% on the prior year’s first quarter. They report some wells have operating costs as low as $5-$7 per BOE.

The clearest indication that existing infrastructure is being used is the need for more. For long term supply/demand, a good place to start is with the INGAA Foundation which periodically publishes their view on natural gas, natural gas liquids (NGLs) and crude oil and their corresponding infrastructure requirements. If the pipes/storage facilities/fractionators etc. are generally not fully utilized, the need for new infrastructure will be reduced.

INGAA recently published an updated long term outlook. It’s instructive to link their 2012 and 2014 forecasts with their current one. Forecasting the supply and demand for natural gas, NGLs and crude oil over twenty years is by no means an exact science. Key inputs include economic growth in the U.S. and elsewhere, government policy regarding carbon emissions and, not least, the prices of the underlying hydrocarbons themselves. Like some Exploration and Production (E&P) companies, INGAA found itself swept up in the promise of the shale revolution. From 2012 to 2014 their estimate of new crude oil infrastructure investment jumped by a factor of eight, only to be slashed by 40% in response to the collapse in crude prices.

INGAA’s current forecast of $7.8BN in annual crude oil-related capex is no more likely to be accurate than in the past, heavily dependent as it is on the future price of oil. In 2014 they based their $12.9BN (annual capex figures are all inflation-adjusted to 2016) forecast of annual capex over 20 years on $100 per barrel, and now they’re forecasting an eventual move to $75 by 2025 (the High Case) or by 2030 (the Low Case). Predicting the price of oil is hard. Although some commentators have claimed the U.S. is the swing oil producer with the ability to quickly ramp up production, PXD’s CEO Scott Sheffield highlighted that although their rig crews could bring a well online in 4-5 months, it would take the U.S industry two years to meaningfully increase production back up, due to a current focus on bringing down leverage as well as the time it takes to rehire and train workers.

While the futures market lets you lock in the prices shown for a year or two, futures are a poor forecast of where the market will actually be. The spot price combined with the costs of storage, impacted somewhat by hedging activity, set the futures price. And yet today’s spot price pays little heed to the approximately $350BN of reduced capex by E&P companies globally, the approximately 5% annual depletion of today’s aggregate sources of production, the 1.5MM bbls/day of annual demand growth, or that global spare capacity is near the lowest levels in history.

By contrast with the unpredictability of crude oil prices and the related infrastructure need, the outlook for natural gas has been remarkably stable. INGAA raised their expectations in 2014 and kept them unchanged in 2016. Beneath the figures though there are some substantial shifts. The north east U.S. is becoming a prolific regional exporter of natural gas, which is creating more demand for take-away capacity as well as causing the reversal of transmission pipelines to run from the north east rather than towards. Insufficient takeaway capacity in the Marcellus has hurt producers[1]. Liquid Natural Gas (LNG) exports via seaborne tankers are a growing source of demand, as are exports via pipeline to Mexico. Canadian bitumen-based crude oil production (‘tar-sands’) uses natural gas to heat the bitumen to a semi-liquid state. The long lead times for such projects assure that Canadian crude production will increase.

INGAA went with a High and Low Case forecast in their 2016 release (figures above are based on the midpoint between the two). U.S. energy infrastructure is much more about natural gas and NGLs, with only 7% of pipelines being dedicated to crude oil. Infrastructure doesn’t get built without customers being signed up. Kinder Morgan (KMI) recently shelved their North East Direct (NED) plan to expand natural gas supply and storage to New England because they could only achieve a projected 6% return. A mild winter caused memories of $40 natural gas to fade in Boston (versus $2-$4 per MCF more commonly). While the project would have contributed to growing earnings at KMI, its cancellation shows why natural gas pipelines don’t normally sit unused. We are invested in KMI.

As the chart (from INGAA) showing annual capital expenditure highlights, a good portion of the infrastructure spend is set to occur within the next few years. Many of these projects are already under construction since the data is presented based on the year that a project is completed; a good portion of the capex will have occurred in prior years.

In spite of last year’s MLP collapse, expected U.S. natural gas and NGL output didn’t change much; America’s energy infrastructure continues to be augmented. Moreover, a good part of the spending is occurring over just a few years. As this grows the asset base of MLPs, it will highlight the substantial advantages enjoyed by MLP General Partners (GPs), for at times of asset growth the MLP GP looks like a hedge fund manager. Our investing strategies and fund are designed to exploit this.

[1] North American Midstream Infrastructure Through 2035: Leaning into the Headwinds. INGAA, Pg 36

Williams Companies Stands Alone at the Altar; Crestwood Delevers and Soars

April 24, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

Williams Companies Stands Alone at the Altar

The Energy Transfer-Williams deal continues to be a rich source of intrigue and fascinating machinations. Sometimes a target company will try and get out of an agreement to sell itself so as to join with a more eager suitor. But it’s not often that an acquirer has second thoughts, and reading through a recent SEC filing by Energy Transfer reveals a blow-by-blow account of the frequent discussions of the William board as they considered their options.

As long ago as February 2014, Energy Transfer Equity (ETE) CEO Kelcy Warren had reached out to Williams Companies (WMB) CEO Alan Armstrong to discuss a combination. Armstrong was initially lukewarm and from the looks of it never became enthusiastic, even voting against the combination when it was finally considered by the WMB board in September 2015.

The “Background to the Merger” is in a section of a filing made, ironically, by Energy Transfer Corp (ETC), an entity created specifically to acquire WMB shares at closing but which for now is doing little more than posting SEC filings. Although ETC is currently controlled by ETE, its filing includes a methodical recital of the WMB board’s consideration of ETE’s offer as well as other competing proposals. Indeed, as the negotiations reached a conclusion WMB insisted on severely limiting ETE’s ability to walk away from the transaction. WMB sought to tighten the “material adverse effect” language that is commonly used and which allows a party to cancel a proposed transaction for no penalty in the event that a major surprise upsets the original economics. Kelcy Warren had pursued WMB for almost two years, and having finally succumbed to their eager paramour the WMB board was intent on making the deal stick.

Buyer’s remorse followed with indecent haste (see The Energy Transfer-Williams Poker Game). Within months ETE’s CFO Jamie Welch was reported to be privately lobbying WMB shareholders to press for modified deal terms, since the $6BN cash payment agreed to by ETE was weighing on the stock price. In fact, the performance of both stocks has been disastrous since the deal was announced, since the new ETC stock with which WMB investors would be paid was to be linked to collapsing ETE, thereby diminishing the value of the sale. It became obvious why ETE wanted out – less clear why WMB insisted on completing a transaction whose value had disintegrated. In May of 2015 ETE’s proposal to WMB had valued the stock at $64. By March of 2016 the prospect of the deal closing had dragged WMB down to $15. By then, Kelcy Warren had fired his CFO (who has sued) and gone nuclear in his efforts to get the deal changed or cancelled; ETE made a possibly illegal and certainly unethical move when they issued preferred equity only to insiders on preferential terms (thus devaluing the currency WMB investors would receive in the transaction, and drawing a WMB lawsuit). In case ETE’s distaste for the transaction wasn’t already clear, they subsequently posted an SEC filing slashing the originally expected $2BN in annual commercial synergies to only $170MM. For good measure they added that the combined company’s presence at WMB’s current headquarters in Tulsa, OK would be substantially reduced.

At this stage both stocks are attractively valued if they remain separate. So it’s interesting to learn how comparatively easy it is for the deal to be broken if the acquirer doesn’t wish to proceed. The merger-arb funds and the journalists who bet on a closing missed this. The New York Times reported on March 4^th that, “…the company’s options appear to be severely limited.” With respect to breaking the deal, last week’s S-4 from Energy Transfer Corp noted that their tax counsel might not be able to deliver a needed tax opinion in time, a necessary condition for closing. One can imagine that if the acquirer doesn’t want to proceed, and an affirmative tax opinion is required from its legal counsel, it shouldn’t be difficult to delay or even fail to obtain such an opinion. Originally WMB didn’t want to be bought and ETE gave chase. Having finally been caught, WMB desires consummation while ETE claims its earlier passion has gone. WMB is at the altar while ETE nurses the mother of all hangovers in a hotel. Did they find each other on Match.com? In this upside-down world of love professed, only to be returned unrequited, it must be difficult for WMB to press a damages claim. Since the abovementioned filing cast further doubt on the deal WMB’s stock has risen. In any event, on June 28^th either party can simply walk away. For Kelcy Warren that date probably can’t come quickly enough. The next target of his affections may run a little faster.

Crestwood Delevers and Soars

On Thursday Crestwood Equity Partners (CEQP) announced a joint venture with Con Edison which placed a 13X EBITDA multiple on the part of CEQP that was rolled into the JV and allowed them to use cash proceeds from the deal to reduce leverage. It was another example of public market equity prices underpricing the value that other energy sector investors assess to be present. Although CEQP jumped over 50%, we believe it’s still attractively priced with a 14% yield following a distribution cut, 1.6X distribution coverage and leverage dropping to <4X by year end. We noted the potential value in CEQP in February (see The Math of a Distribution-Financed Buyback)

Sell-Side Shockers

Meanwhile, MLPs have since February kicked off the casket lid and leapt up, showing vigorous signs of life. Many formerly wealthy MLP investors who hung on are no doubt relieved to be restored from potential mobile home dwellers to at least the category of mass-affluent. Sell-side coverage of the sector is becoming more cautiously constructive, buoyed by the Alerian Index finally reaching positive territory year-to-date. We came across one amusing recommendation from a clearly overworked analyst whose bosses evidently decided to issue an emergency research piece initiating coverage on MLPs. The hapless analyst breathlessly rates Columbia Pipeline (CPGX) “Market Perform”, failing to consider TransCanada’s (TRP) recently agreed acquisition of CPGX for $25.50 in an all cash deal. So regardless of how the market performs CPGX is going to $25.50. The same analyst thinks WMB investors will suffer a 50% dividend cut if the merger with Energy Transfer goes through, overlooking the 1.5274X ETE exchange ratio they’ll receive for their WMB shares. Who says sell-side research isn’t worth reading?

We are long CEQP, ETE and WMB in our mutual fund and separately managed accounts.

Chart source: Yahoo Finance

Energy's Winners and Losers

April 17, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

The U.S. Energy Information Agency (EIA) is a powerful resource for those interested in the topic. They recently noted that in 2016, natural gas-fired power generation would exceed coal for the first time in history. 18.7 gigawatts (GW) of new gas-fired capacity is due to come online between now and 2018 replacing dirtier coal plants as they are gradually phased out. Moreover, much of this new capacity is located near its source of energy, so Pennsylvania, West Virginia and Ohio (Marcellus and Utica shales) as well as Texas and Louisiana (Eagle Ford and Haynesville shales) have seen much of this added capacity. The travails of the coal industry are well known, with the bankruptcy filing last week of the world’s biggest coalminer Peabody Coal (BTU) highlighting the economic challenges of producing the dirtiest fossil fuel. Cheap natural gas has long been on course to supplant coal for power generation in the U.S. The EIA’s Annual Energy Outlook 2015 forecasts natural gas to move from 27% to 31% of electricity generation by 2040. Only renewables will also enjoy an increased share, with Nuclear and Coal both slipping in importance.

What’s taking place is a fairly dramatic transformation of the ways in which the U.S. uses energy compared with as recently as five years ago. The unlocking of vast amounts of natural gas has provided very competitively priced power for industry, cheap ethane feedstock for use in the production of plastics and by displacing coal has allowed the U.S. to curb its production of greenhouse gases. This last point is especially ironic since the U.S. never signed up to the Kyoto Protocol, whose goal was to limit emissions of carbon and other pollutants.

Sometimes when chatting with clients about energy consumption and fossil fuels I’m asked why we don’t worry about electric cars and solar power upending the sourcing and consumption of electricity. Electric cars sound clean, but it depends on how the electricity they use is generated. The good news here is that it’s increasingly from relatively clean natural gas although it does vary across the United States. A friend of mine is planning to buy a Tesla, and her environmentally-sensitive decision is supported by the virtual absence of coal-fired electricity production in New York and New Jersey where she’ll be driving. Wyoming may offer spectacular scenery and an environment worth saving, but with 89% of its power coming from coal a Tesla won’t much help the environment there. West Virginia and Kentucky are similar.

Renewables are expected to gain in importance, going from 13% of our electricity generation to 18% by 2040 according to the EIA as the first chart shows. Solar energy will grow at a fast rate but from a very low base, as is shown in the second chart. It looks to me as if my grandchildren will reach retirement before they inhabit a world in which solar is the dominant source of energy. Although we invest for the long term, that’s too far out even for us to incorporate into our thinking.

Low prices for crude oil and natural gas have also created challenges across many industries beyond their own. For example, the economics of renewables, including solar, have suffered from cheaper competing fossil fuels. SunEdison (SUNE) is close to bankruptcy as it grapples with this problem. Banking hasn’t been immune — JPMorgan, Wells Fargo and Bank of America all reported higher loan loss reserves against their energy portfolios last week. And last October, somewhat improbably, United Airlines blamed a disappointing quarter on fewer corporate executives flying to visit oil fields; most would think cheaper fuel is good for airlines.

Although last week saw the bankruptcy of the biggest miner of “old” fuel in Peabody and the pending demise of a champion of new energy in SunEdison, Tallgrass Energy (TEP) had a good week. This Master Limited Partnership (MLP) provides natural gas transportation and storage services in the Rockies and Midwest through their Tallgrass and Trailblazer systems. TEP has a publicly traded General Partner (GP) called Tallgrass Energy GP (TEGP), which runs TEP. As is invariably the case, management is invested in TEGP rather than TEP. If you want to invest alongside management in an MLP it usually pays to own the GP instead. In the case of TEGP and TEP, management insiders have around $1.9BN invested in the GP and only 18MM in TEP itself, a difference of 101X. They obviously have an opinion about the relative merits of these two securities. Last week, TEGP raised its quarterly distribution by 21.4% compared to the previous quarter. Not every part of the energy sector is struggling.

We are invested in TEGP

Drilling Efficiencies, Crestwood and More Energy Transfer-Williams Shenanigans

April 10, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

Drilling Efficiencies

A week or so ago the Energy Information Agency (EIA) released the results of a survey showing the average cost to drill and complete a well in four of the major producing regions in the U.S. As the EIA chart shows, costs were rising going into 2012, but thereafter started to fall and maintained that trajectory as exploration and production companies aggressively sought improved efficiency from their technology and their service providers.

Although this drop in well costs has obviously been good news for the E&P industry (albeit less so for their service providers) it has been complemented by greater output per well. Using data from the EIA’s Drilling Production Report we have created the four subsequent charts, showing, respectively, output per rig for crude oil and natural gas, and total production of crude oil and natural gas, for each of the four regions highlighted by the EIA. Reduced costs to complete a well might accommodate lower average production per well, but in fact the reverse has generally been happening which has allowed IRRs (Internal Rates of Return) to remain substantially more attractive than would otherwise have been the case.

Natural gas production efficiency has improved dramatically in the Marcellus, which has caused the north east U.S. to switch from being a natural gas importer to an exporter and has begun to displace supplies from eastern Canada.

This is why crude oil and natural gas production have only fallen appreciably in the Eagle Ford, where higher initial production rates of new wells (due to higher pressure) are more than offset by faster decline rates than in other regions.

Natural gas output has soared in the Marcellus, aided by falling costs and a more than five-fold increase in output per rig since 2010. And meanwhile the rig count has come down sharply, as the table shows (Source:EIA).

This all represents a fantastic example of American technological innovation rapidly responding to the collapse in crude oil, probably faster than most observers had any reason to expect. Who would want to bet against continued American advances and improvements in this sphere?

Crestwood

A couple of months ago we wrote about Crestwood Equity Partners (CEQP), in The Math of a Distribution-Financed Buyback. Quicksilver is a bankrupt E&P company that had asked the bankruptcy court to reject Crestwood’s contract to provide gathering and processing services. There isn’t much case history of courts resolving contractual disputes between MLPs and their customers, but the travails of many domesric drillers has certainly drawn attention to this aspect of the MLP business model.

On Wednesday, Crestwood announced they had signed a ten year agreement to provide such services to BlueStone Natural Resources, the acquirer of Quicksilver’s Barnett Shale acreage. Previously shut-in wells will be re-opened and the contract, which consists of both fixed-fee and percent of proceeds terms, commits BlueStone to refrain from constraining production for economic reasons through the end of 2018.

It’s just one contract out of tens of thousands across the industry, but its constructive resolution highlights the symbiotic relationship between E&P companies and their infrastructure providers.

Energy Transfer and Williams

Last week we wrote about the Energy Transfer-Williams Poker Game and further twists in the plot took place since then as Williams (WMB) sued Energy Transfer (ETE) and CEO Kelcy Warren for violating the merger agreement when they issued convertible securities only to ETE management. There are no sympathetic characters here, but one can already hear the WMB lawyer explaining in court that WMB initially rejected ETE’s overtures, then finally agreed and is simply seeking to close the transaction on the agreed upon terms. Or, ETE pursued WMB in spite of being rejected, finally got the deal they wanted and have now changed their minds.

I guess Kelcy Warren has earned the right to blunder; while it’s impossible to forecast a resolution, it’s becoming a little hard to envisage a happy combination of these two companies under present circumstances. The uncertainty represents a substantial pall over both stock prices; a grudging break-up payment from ETE to WMB might well be the outcome that lets both managements focus on their operating businesses and brings this sorry, absorbing episode to a conclusion.

One solution that distribution loving MLP investors will find almost unbearable to even ponder is for ETE to scrap the preferred offering, close the deal per the original agreement and suspend the distribution. With $4BN a year in cash flow at the pro-forma parent the $6BN cash payout would be retired in a year and a half with investors looking at a combined company trading at 3x cash flow with conservative leverage.

We are long CEQP, ETE and WMB.

The Energy Transfer-Williams Poker Game

April 3, 2016/3 Comments/in Midstream Energy Infrastructure/by Simon Lack

The managements of Energy Transfer Equity (ETE) and Williams Companies (WMB) are engaged in a high stakes poker game. It’s an absorbing spectacle. Last May WMB announced plans to buy in its MLP Williams Partners (WPZ). As with Kinder Morgan, they felt their size as well as the drag from Incentive Distribution Rights (IDR) from WPZ to WMB was making it hard to identify accretive growth projects. Kelcy Warren, ETE’s CEO, made an unsolicited offer for WMB and after fending him off for several months WMB eventually agreed, grudgingly, to be acquired in September. They dropped their earlier plan to merge with their MLP.

Almost immediately ETE was struck with buyer’s remorse. The deal terms included an $8.10 cash payment from ETE for each WMB share, and as MLPs sank this $6BN payout represented an increasing percentage of the deal as well as an unneeded strain on ETE’s balance sheet. ETE had crafted a complex transaction. They were keen to maintain the GP/MLP structure, since Kelcy Warren clearly recognizes the value in an MLP GP (see Energy Transfer’s Kelcy Warren Thinks Like a Hedge Fund Manager). However, ETE couldn’t simply issue new units to exchange for WMB shares to satisfy the non-cash component, because ETE is a partnership that generates a K-1 and WMB shareholders wouldn’t want to exchange their shares in a corporation generating a 1099 for LP units. So ETE agreed to exchange 1.5274 shares in the newly formed Energy Transfer Corp (ETC) for each WMB share.

ETC is supposed to track ETE for two years following the transaction close through a mechanism designed for the purpose, but it’s a novel approach and it’s unclear how they’ll both trade after that. The complexity shows how keen Kelcy Waren was to buy WMB and so retain their MLP as a stand-alone vehicle still generating IDRs for its GP. But as ETE, WMB and MLPs generally fell, ETE’s CFO Jamie Welch apparently began looking for modifications or even a way out of the deal without having to pay a break-up fee. In fact, Jamie was visible in telling WMB shareholders they should reject the transaction, and last month he was fired.

Whether Jamie was fired because he crafted a poor deal or because he was using the wrong strategy to change it, Kelcy Warren soon went on the offensive. In quick succession ETE announced two transactions designed to make ETE and its doppelganger ETC less valuable by enriching senior management at the expense of other ETE/ETC shareholders including, should the transaction close, WMB shareholders.

On March 10^th Energy Transfer announced a limited offering of convertible units available only to insiders and on preferential terms. They followed this up with a substantial grant of new shares by way of compensation to ETE management to take effect after the closing of the WMB transaction. Both moves served to make ETE/ETC a less valuable currency to WMB shareholders, but the collateral damage was to all the existing non-insider owners of ETE. The clear message to WMB’s board is, sit down with us and renegotiate this deal or we’ll make it progressively less attractive to you.

What was unsaid publicly was no doubt communicated clearly in private; these terms stink and if you disagree we’ll make them worse. If WMB walks away they have to pay ETE a 1.5BN break-up fee, unless it’s voted down by WMB shareholders. If both companies agree to break up, ETE has to pay WMB $410MM, the same fee WMB had to pay WPZ when that deal was cancelled. There is no provision for ETE to walk away, so they’d likely face a lawsuit for substantial damages if they did. Considering the deal originally valued WMB at $43.50 compared to its Friday close of $15.52, you’d think pursuing such a lawsuit would be challenging. More recently, to confirm what a bad idea the merger was, ETE took its earlier forecast of $2BN in annual synergies down to roughly zero.

Apparently the WMB board never was that enthusiastic about the deal in the first place, with CEO Alan Armstrong opposed while activist hedge fund manager Keith Meister was in favor.

Kelcy Warren has become a billionaire through the Energy Transfer family of businesses which he founded in 1995. The deal’s proponents on WMB’s board, including Keith Meister of Corvex, are struggling to show that their earlier advocacy was astute given the subsequent collapse in both stock prices. These billionaires now rather resemble elephants dancing in a cramped tea room; the question for investors is how to avoid being the crushed china set in the process, for both men hew to their fiduciary obligations only as long as more important considerations don’t intervene.

Two years ago Keith Meister showed his true colors with alarm company ADT, when in April 2014 he relied upon a stock buyback for which he’d advocated to sell his big ADT position back to the company. ADT’s stock price subsequently sank 30%. ADT’s CEO Nareen Gursahaney was shown to be inept (see ADT and the Ham Sandwich Test) while Keith Meister created further obstacles for those who believe all hedge fund managers are misunderstood altruists.

So ETE’s strategy is one of devaluing its acquisition currency to the point that it’s unattractive, while WMB’s is one of holding out presumably in the hope of a big break-up fee. And yet, since what’s good for ETE must be good for WMB, it’s obvious that there’s a shared interest in reducing the cash portion of the deal in exchange for more equity. The outline of an agreement is clear to everybody, but so far a WMB board that was split and an ETE management that has completely changed its mind cannot put their egos aside and find common ground. It’s mostly about the capital structure of the combined entity. If they get that right both sides will win. But it also shows that there’s more than one way to handle the funds of public shareholders. Few players in this story are showing themselves to be responsible stewards of client capital. In years to come, situations like this will beg the question: how would Buffett have handled it. Whatever the answer, it won’t be like this.

We are invested in ETE and WMB.