Last week I was in Las Vegas for 48 hours attending a conference. Dear reader, before you smile at this lame attempt to disguise play as work, you should know that I don’t gamble, drink only moderately and do not enjoy loud rock music. Therefore, the sight of yours truly staying at the Hard Rock Hotel and Casino might strike you as incongruous to say the least; I can report that the thumping rock music is as inescapable as the screens of Big Brother in George Orwell’s book 1984. Elevators and bathrooms offered no escape.  Fortunately, I was with many friends from Catalyst Funds, our mutual fund partner, and their company made it a thoroughly worthwhile and enjoyable visit. However, as my wife noted, if you’re planning a weekend of alcohol-infused debauchery and gambling, I might not be your best choice of travel companion.

Las Vegas stands for many things; as I walked through the hotel casino full of hopeful slot machine fanatics and blackjack buffs it reminded me that the entire city stands as a testament to a glaring failure of classical economics. In the theoretical world where individuals make rational decisions to maximize their utility, Nevada’s gaming tables with their negative expected outcomes should have no place. The cheerful acknowledgment of punters that the odds favor the house further illustrates how poor are the economist’s tools for explaining the world. One can only square the circle by allowing that the irrational hope of winning big provides positive utility to those relieved of their cash. State-run lotteries work on the same principle, and we non-lottery buyers theoretically pay slightly lower taxes as a result (although that’s hard to believe in New Jersey). The surest way to win is to be a free-rider; the Hard Rock Hotel’s $43 nightly room charge dramatically underprices the facility, because they rely on guests contributing substantially more in the casino. As a stalwart non-participant, I thank my fellow guests for subsidizing my stay. Meanwhile, consider the tormented soul whose $150 “safe” bet on Michigan State to beat Middle Tennessee in the NCAA tournament was lost but would in any case have only paid out $2.15. Let’s at least hope he derived some modest pleasure from temporarily anticipating his winnings. This is someone with a gambling problem.

There have been moments as an MLP investor in recent months when selling out and placing everything on black might have felt more rational and maybe even offered better results. The constant search for good odds in financial markets renders casinos uninteresting, even while MLPs for a while seemed like a faster way to lose money. Fund flows have certainly been an important driver of near term performance, as noted in last week’s post (Up Is The New Black). Figures on MLP fund flows provided recently by JPMorgan were striking, showing that in February $570MM of net inflows came into the sector. This is a substantial show of confidence by retail investors; it more than offset the net outflows ($543MM) that occurred during the entire second half of 2015, during which MLPs sank by 24%. The -0.5% February loss in the Alerian Index masks the substantial intra-month collapse and rebound that the $570MM of inflows helped fuel.

The appetite of retail investors to buy, and then sell, and now buy again MLPs has been a significant factor driving performance. As noted in The 2015 MLP Crash; Why and What’s Next, for a time such investors bridged the gap between MLPs’ need for growth finance and the limited desire of traditional investors to meet it. Direct investors in MLPs who receive K-1s are the quintessential long term investor, not least because time steadily worsens the tax consequences of selling. Retail investors through mutual funds and ETFs are not always so tax-sensitive, and therefore more reactive to recent performance. February’s substantial inflows reflect this shift to more positive sentiment.

For those who follow MLPs closely, one of the enduring mysteries must be the mindset of investors in the Alerian MLP ETF (AMLP). Investors who desire MLP exposure but don’t want K-1s have been attracted to AMLP and a whole host of other inefficient ETFs and mutual funds. As we’ve written before (see, for example, The Enormous Misunderstanding About MLP Funds and Taxes), funds such as these convert the K-1s they receive into the 1099s desired by their investors by paying corporate income tax on their returns. The result is that an investor in a C-corp MLP fund such as this earns substantially less than the index – somewhere close to 35% less since that’s the portion ultimately paid to the U.S. Treasury.

It’s all disclosed in the prospectus, and credit Ron Rowland for first pointing out this pretty fundamental weakness back in 2010. But it turns out few investors or their financial advisors make it to page 5 of the document where the paragraph on “Tax Status” explains that AMLP is a corporate tax payer.

The result, as would have been clear to anyone who carefully examined the fund’s structure and is shown in the first chart, was that AMLP lagged the Alerian Infrastructure Index (AMZIX) from its launch until the market peak in August 2014. Then as the market turned down, AMLP fell less quickly, since it had an accumulated Deferred Tax Liability (DTL) on which to draw. It provided, in an odd sort of way, less volatile exposure to MLPs because the taxes acted to dampen movements both up and down.

The second chart shows monthly returns for AMLP alongside AMZIX since its launch in 2010. Visually, you can see that the moves in AMLP both up and down are generally less than the index against which it is benchmarked.

In August 2015, a year into the MLP bear market, this relationship changed in a way that was disadvantageous to the AMLP investor, in that AMLP began matching the moves in its index rather than moving less than the market. The reason is that AMLP had exhausted its DTL. Taxes are owed on unrealized gains, and the market had fallen far enough to wipe them out completely. As those gains became losses due to further drops in MLPs, AMLP was unable to carry a Deferred Tax Asset (DTA) because of its status as an open-ended investment company. While an operating company can offset losses against future taxable gains, AMLP and its peers cannot.

The third chart focuses in on the monthly swings in AMLP and AMZIX since August 2015 to show that they are much more closely matched.

This is an extremely poor bargain for AMLP investors, because since then they have continued to absorb 100% of the losses in the market but on a recovery, as soon as AMLP gets back to having unrealized gains on its portfolio the taxes will kick back in and investors will once more only receive 65% of the upside. It’s like betting $100 on red at Roulette knowing you’ll only get paid $65. In July 2015 we forecast that this would happen if prices continued to fall (see The Sky High Expenses of MLP Funds). It’s likely that all taxable MLP funds face the same return asymmetry, since MLPs fell far enough to wipe out unrealized gains across the board.

The tax drag shows up in the expense ratio, which for AMLP is currently an eye-popping 5.43%, of which 4.58% is taxes. Virtually no-one I’ve spoken to who’s invested in AMLP is aware of this, as I know from numerous conversations on the topic. The discovery is invariably met with a combination of horror and embarrassment.

The yield on AMLP doesn’t reflect the tax drag, because the taxes come out of the NAV. So while Morningstar lists the yield as 11.81%, a discerning investor would deduct the 4.58% tax drag from this figure to arrive at 7.23%, substantially below the yield on AMZIX.

The defense of the fund’s structure is that it provides MLP exposure without the K-1s, and it does that after a fashion. But in my experience few investors truly comprehend the substantial loss of performance they suffer because of this. It’ll be no surprise to its designers, but AMLP has underperformed its benchmark over every time period since inception other than last year when the tax drag temporarily reduced its downside.

In fact, AMLP’s structure made it the perfect shorting vehicle for hedge funds seeking to bet against MLPs last year, and there is ample anecdotal evidence that this was going on. The asymmetry of its returns (up 65% of the market/down 100% of the market) clearly works to the benefit of the short. In addition, while shorting a security renders you liable for the dividends paid to investors, AMLP’s expense ratio was a substantial mitigant because the tax drag reduces the NAV. In this way, the tax costs incurred by the investors act to reduce the financing costs for shorts, so AMLP investors by owning the security were aiding the very market participants whose objective was to drive down prices and force them out of their investment with losses. Given how MLPs performed last year, hedge funds shorting AMLP evidently enjoyed some success.

The Mainstay Cushing MLP Fund (CSHAX) is similarly structured and invariably underperforms its benchmark. Portfolio Manager Jerry Swank was asked by Barron’s in June 2012 why the fund had lagged its benchmark since inception in 2010 and he replied, “As a corporation, what a mutual fund gives up is a tax drag on the net asset value, as much as a 38% tax drag on NAV.” CSHAX has an expense ratio of 9.42%, of which 7.94% is taxes.

The questioner should have asked, ‘Can you really claim to put investors’ interests first if you design a vehicle like this?’ Instead she moved on, but really; who seriously expects a mutual fund to pay away almost 8% of its clients’ capital in taxes? Funds such as these rely on the cursory examination most retail buyers give to the terms of their investment. They trust finance professionals to recommend thoughtfully designed securities, and that trust is not always well placed.

These securities and others like them (we calculate there are around $20BN outstanding) are deeply flawed. They exploit the unfortunate proclivity of many investors towards superficial research and while their shortcomings are disclosed in documents they’re certainly not understood by their investors.

If you own AMLP, CSHAX or any of the other highly-taxed MLP funds (the clue is a high expense ratio), all is not lost. While their purchase was an error, you can sell now and take the tax loss, maintaining your exposure to a deeply undervalued sector with a RIC-compliant MLP fund properly structured so as to not be a corporate taxpayer. And if your financial advisor has invested your money in a taxable MLP fund, call and ask him if he knows what the expense ratio is that’s eating away at your investment. He’ll probably pay closer attention to fund structure in the future.

MLP managements have been verbose in the last couple of weeks. This is mostly due to the fact that it’s earnings season and conference calls provide an opportunity for investors to obtain additional color from senior executives. It’s the topic of our March newsletter which will be published on Tuesday, but there are many more interesting statements than the newsletter can accommodate.

The elephant in the MLP room is whether distributions will be maintained. Some of the yields are almost willfully defiant, in that they challenge the analyst to hold an opinion. For example, Energy Transfer Equity (ETE) yields 16.7% as of Friday’s close. This is almost certainly a temporary yield; bears will argue it is unsustainable and the distribution will be cut, while bulls will maintain that it is secure. A year from now ETE will probably have moved sharply in one direction or another depending on which view prevails. It is hard to be ambivalent about a 16.7% yield. This is a market that demands strong opinions. Some simple Math shows that if you buy a security yielding 16.7% and over the following year its yield drops by 2% due to price appreciation (reliably paying that 16.7% yield for a year will likely draw in new buyers), your total return is 30%. MLPs should offer this type of possible return, because recent weeks have shown that a 16.7% yield can be offset by a few bad days. But considering the paucity of return potential across other asset classes, it’s hard to see how any serious investor can evaluate her choices without thinking pretty hard about this sector. You may reject a possible 30% one year return as not worth the risk or unattainable, but a failure to consider it is lazy. A 16.7% yield challenges the observer to investigate further.

ETE’s CEO Kelcy Warren naturally maintains that the payout is secure, allowing himself virtually no wiggle room. While asserting that no distribution cuts were contemplated across the Energy Transfer complex, he said, “Our distribution cuts are not required at ETE. And we take our obligation to our unitholders very, very seriously. We have a duty to maintain our distributions. But everybody knows, obviously, that’s an option to the extent of that we need access to distributions to maintain our financial health at ETE; would we reach in to that bucket, it would be the last one we’d reach to, but it’s certainly possible.” Of course, no CEO highlights the likelihood of a cut until it’s done, at which time it appears inevitable. We’ve made our bet, because managements at ETE and other businesses are reducing capex, eliminating their need for new equity and paying close attention to the ability of cashflows to service debt and continue distributions. They are generally doing the right thing. So we side with Kelcy. But it’s also true that while a distribution cut represents a betrayal of your investors, if the cash is used to fund accretive growth projects so as to avoid the dilution from issuing additional equity, as Kinder Morgan (KMI) argued, there’s nothing theoretically destructive to value. On December 8, the day KMI announced its dividend cut, the stock closed at $15.72 and is now at $17.76. Berkshire Hathaway (BRK) doesn’t need stocks that pay high dividends; their challenge is finding good places to invest their cash, and KMI’s subsequent reliance on internally generated cash to finance growth probably made them more attractive in Omaha.

Cheniere’s LNG export facility in Sabine Pass, LA exported its first batch of natural gas last week. The Wall Street Journal published an insightful article highlighting the attractiveness of the U.S. as a supplier to countries such as Lithuania, who are tiring of Gazprom’s hard-line negotiations that typically start on New Year’s Eve when the threat of a mid-winter supply disruption hangs over the price discussions.

The photo is a satellite shot of the U.S. at night, and while most of the lights are in population areas the white box highlights North Dakota where there are few people but lots of gas flaring. Oneok’s CEO Terry Spencer commented this week, “So flared gas, let me just tell you, it’s not an exact science. And it’s quite possible we could have more flared gas than we actually believe we have, because every time we turn on a compressor station it seems like the wells behind that particular compressor station outperform our expectations. Time and time again, more gas is showing up than what we thought.” Since flaring is both bad for the environment as well as commercially destructive, those in favor of additional infrastructure to capture this lost output must include environmentalists, involved E&P companies and indirectly the Lithuanian electricity consumer. The U.S. is on its way to becoming a significant exporter of hydrocarbons, and its reliability will compare favorably with many of the competing exporters. If you choose not to buy from unstable regions or unpredictable kleptocracies, your choices of supply can be limited.  The shifting geopolitics is the long game, but is hardly reflected in today’s asset prices.

We are invested in BRK, ETE, KMI and OKE

 

Around ten days ago Conoco Phillips (COP) and Magellan Midstream (MMP) both released their 4Q15 earnings, and held conference calls on February 4th to discuss them. This coincidence of reporting is about all they have in common, but it caused us to look a bit more closely at an energy company (COP) that truly has commodity price exposure and what it’s doing about it.

COP announced a two-thirds cut in their dividend, a completely understandable move because they really are financing it with debt. The problem with an Exploration and Production (E&P) company like COP is that they have to keep replacing their assets. Hydrocarbons produced are assets no longer available to generate future revenues, and so they keep investing in new future production. Consequently, COP’s $3.3BN of 2015 EBITDA was dwarfed by $10BN of capex resulting in negative free cashflow (FCF). They lost $3.50 per share. The company closed out the year with half the cash with which it started ($2.4BN versus $5.1BN) and on top of that their proved reserves fell by 19%, from 8.9 BBOE (Billions of Barrels of Oil Equivalent) to 8.2 BBOE. Incidentally, COP’s 2015 Depreciation, Depletion and Amortization (DD&A) was $9BN, pretty close to their capex. Their new investments were approximately equal to the hydrocarbon assets they extracted and sold. In 2016 their DD&A is likely to exceed their capex by $2BN. They are running very hard and not even moving forward. 2015 was a year COP will happily forget – they lost money, used up half their cash and saw their reserves drop. They have nothing to show for it.

It’s hard to know how to value COP, and especially hard to compare them with an MLP (which is where we’re going). Neither their free cashflow yield nor their P/E multiple are meaningful since both are negative. On an Enterprise Value/EBITDA (EV/EBITDA) basis they’re priced at 15.4X based on 2016 guidance, which incorporates a 36% slashing of their capex budget to $6.4BN. This multiple flatters COP and all E&P companies though, because it backs out depletion and depreciation although their future EBITDA is dependent on continuing growth capex to replace what’s gone.

COP’s dividend cut was a belated acknowledgment of the obvious, which is that they don’t generate any cash to pay a dividend so are funding it with debt. In fact, COP operates in the way that many MLP critics assert is prevalent with midstream infrastructure businesses, although there are substantial differences between the assets of an E&P company (hydrocarbon reserves which are used up) and pipelines which last for decades and don’t require perennial replacement (although they do require maintenance).

MMP reported solid earnings and generates Distributable Cash Flow (DCF), a measure somewhat analogous to COP’s FCF (although MLP critics will disagree on this point). MMP’s DCF covers their distribution, whereas COP really has no business paying a dividend. MMP’s EV/EBITDA, in which their EBITDA is more reflective of FCF generation because its assets are not naturally depleting, is 15.3X on 2016 guidance, roughly the same as COP’s.

Now it’s true that COP has tracked the Alerian Index (AMZX) more reliably than MMP, which is to say MLPs have behaved like an enormous cash-consuming owner of depleting assets rather than the cash-generative owner of sustainable assets that they are (chart source: SL Advisors). The few E&P names in the Alerian index have been dumped following distribution cuts (reliable distributions are one of the  the rules for inclusion), so AMZX no longer includes E&P businesses. MMP has outperformed AMZX, and yet its valuation fails to differentiate it from COP. It has been dragged down by its sector.

We continue to think that the ongoing collapse in MLPs is reflective of their financing model and rigidity of the investor base (see The 2015 MLP Crash; Why and What’s Next). Traditional MLP investors are U.S. taxable, high net worth (HNW) individuals. The arrival of smaller retail investors through mutual funds and ETFs for a time met the increased need for growth capex that traditional MLP investors, who like their distributions, didn’t want to finance by reinvesting everything they received. The retail investor was the marginal buyer, for a while. The surprise has been that upon his exit, new sources of financing have required a substantial price discount. MLP proponents have written for years about the institutionalization of the sector. The evidence clearly shows that once you exclude institutional money managers of retail money, the true institutional investors of public equities (pension funds, sovereign wealth funds, endowments and foundations) are not natural MLP investors because of the tax barriers.

Deciding the sector is cheap and then identifying a manager and implementing is a deliberate process, and while we see some evidence that it is under way, the buyer of an MLP today is most likely still the traditional HNW taxable investor. Given the collapse in prices, he’s not very enthusiastic. In this way, the MLP sector is unlike any other sector of the U.S. equity markets where capital can move in more opportunistically. Eventually, institutional investors will commit more meaningful capital, but it takes time. Most of the publicly listed MLP funds are terribly tax-inefficient (see The Sky High Expenses of MLP Funds), although not ours. As well as selecting a manager to oversee an MLP portfolio, a non-tax paying pension fund must decide to file a tax return (as direct holdings of MLPs would require). These are not trivial decisions. Count the cheerleaders for the “institutionalization” of the MLP sector among those whose views were aspirational rather than realistic.

We are invested in MMP.

Given the collapse in MLP prices over the last six months virtually any explanation is worth considering. Operating results continue to be unremarkable – Kinder Morgan (KMI) reported 4Q15 financials last week. Their full year 2015 results were 4% lower than their budget; two thirds of the miss was in their CO2 business which is sensitive to the price of crude oil. Overall they generated $7.6BN of EBITDA versus a budgeted figure of $7.9BN. Their Distributable Cash Flow of $4.7BN was 7% higher than in 2014. In April KMI was at $44, and closed the year at under $15.

But operating performance has never come close to justifying the performance of MLPs recently, hence we have cast around for other explanations. The rigidity of the investor base is, we think, an important cause (see The 2015 MLP Crash; Why and What’s Next). Another frequently raised concern is that the rates MLPs earn on their pipelines will be reduced, either because loss-making E&P companies will renegotiate terms or because they’ll fail and a bankruptcy court will impose a lower rate. Although there’s very little history of this, the views of the investor who chooses not to buy MLPs can be more useful than those of the MLP seller, and this issue is being raised more frequently.

It sounds plausible that if the company filling a pipeline with hydrocarbons at one end is losing money, the pipeline owner should care. A pipeline’s immobility requires reliable customers. An E&P company that is unwilling or unable to use previously contracted capacity can cause problems for the pipeline owner as well as for the customer at the other end awaiting receipt of the product.

The U.S. has 192,396 miles of liquids pipelines of which roughly a third each move crude oil, Natural Gas Liquids (NGLs) and refined products. There are over 302,000 miles of natural gas pipelines. There are over 240,000 miles of Gathering and Processing (G&P) lines – often single individual pipes to a single well. These are both narrow and numerous. There are nearly 2.2 million miles of natural gas distribution lines from utilities to residential and commercial customers. Historically, their utilization has been remarkably reliable. While Gazprom occasionally uses its power as a supplier to further Russia’s foreign policy objectives, it’s hard to think of an example where a domestic commercial dispute has impeded the flow of product. Once pipelines are built, they are used with a high degree of predictability. The Federal Energy Regulatory Commission (FERC) governs all natural gas pipelines (other than G&P) and all other pipelines that cross state lines. Interestingly, the thrust of regulation has largely been to limit the power of the pipeline operator, since a customer on the receiving end of a pipeline has few plausible choices if he’s suddenly faced with a price hike. Although a single pipe is immobile and obviously creates a symbiotic relationship with its customer, it’s part of a network which makes the product mobile, affording its owner substantially more flexibility on where to send product than the customer has on where to obtain it. Part of FERC’s role is to control the ability of MLPs to exploit this. Security of supply requires predictability of income. Pipeline projects are cancelled before breaking ground if insufficient commitments are in hand to assure its financial viability. In 2013 Kinder Morgan cancelled the $2BN “Freedom” pipeline that was intended to transport crude oil from West Texas to California for just this reason. The Field of Dreams approach is not widely used.

There isn’t a long history of broken pipeline contracts from which to draw examples. Disputes are hard to find, probably because there’s so little legal ambiguity.  Last year an Indian steel company, Essar Steel Limited, lost a case in Minnesota federal court when their acquisition of a local steel company led them to break an agreement with Great Lakes Gas Transmission Limited Partnership to take their supply of natural gas (used in steel production). Essar’s contention that the global economic crisis invalidated the contract was rejected by the court, which awarded $32.9 million to the plaintiff.

FERC has authority over many potential disputes. In 2015 Buckeye Partners reached agreement following a long-running dispute with several airlines over the rates they were charging to deliver jet fuel from New Jersey to three New York area airports. FERC oversaw the agreement and approved its resolution.

It can be useful to think of pipelines as networks of tributaries from individual plays feeding into processing centers and then into large-capacity trunklines on their way to population centers, power stations, refineries, export facilities and other users. Recently, “farther from the wellhead” has guided the investment recommendations of some, and it makes sense that a G&P network supporting a new, high cost crude oil baisin involves a totally different risk than a natural gas pipeline running into New York City to supply a power station’s electricity production.

Pipelines that are “demand pull,” in that they’re paid for by the end-user (such as a refinery or power station) are less risky than “supply-push”. In addition, 75% of hydrocarbon production in the U.S. is done by investment grade companies, so performance risk ought to be limited. Take-or-pay contracts assure the pipeline operator of revenue regardless of whether the E&P company uses the capacity. Like virtually all U.S. commercial contracts, they are enforceable. None of these seem to represent significant risk of changing contract terms. The place to look for problems is close to the wellhead where a bankruptcy judge is overseeing a failed E&P company’s obligations. However, bankruptcy need not impede the flow of product, since the bondholders could continue operations with a reduced cost of capital having shed the equity holders. While it’s conceivable that a struggling E&P company could seek to renegotiate a contract with the threat of shutting in the well, the problem of weak prices is one of excess supply. Other producers would presumably be willing to use capacity albeit not necessarily in the same place.

2015 saw 41 energy companies file for bankruptcy representing $16BN in debt. So far there are few reports of any meaningful consequences for the MLPs that provide their infrastructure, although there are reported instances of contracts being renegotiated. Williams Companies (WMB) and Chesapeake (CHK) have agreed on lower rates for natural gas transportation in Ohio and Louisiana in exchange for higher future volumes, but this is not a typical case: CHK spun out their midstream assets into Access Midstream with unusually lucrative contracts probably because they were more highly valued by Access investors than their cost as reflected in CHK’s valuation. WMB subsequently acquired Access Midstream. In Pennsylvania, leasehold contracts have been challenged by the state on behalf of many landowners who have seen their royalty checks for drilling leases slashed. But it seems so far to be an isolated case. In another interesting case brought to my attention by Ethan Bellamy of RW Baird and also Dick Flex (see comment on right panel), Quicksilver Resources , which is in bankruptcy, continues to send natural gas through Crestwood Midstream’s (CEQP) G&P network, although Quicksilver is seeking to renegotiate their agreement and has used bankruptcy to reject contracts with other G&P firms. Bankruptcy doesn’t have to lead to a cut in production. Kinder Morgan’s recent results did include a $45 million credit charge in their Terminals business due to two failed coal companies. Of course this reflects the shift away from coal towards natural gas, a trend for which MLPs including KMI are well positioned.

Moreover, demand is not the problem. Last year in the U.S., natural gas production of around 80BCF (Billion Cubic Feet Per Day) was 4BCF higher than in 2014. Exports are expected to double this year. Auto sales were a record 17.5 million with gas-guzzling pick-ups and SUVs representing half of this. Cheap hydrocarbons are producing a demand response.

While MLPs have always paid attention to the credit profile of their customers, there is increased focus on this area from investors.  We’ll continue searching for examples of the likely impact on an MLP when its E&P customer fails.

A poorly designed MLP product Crashes

This could almost be the topic of a second blog post: last week UBS announced the mandatory redemption of two exchange-traded notes that were designed to provide MLP exposure leveraged 2:1. The results have been predictable, and the notes (ticker: MLPV and MLPL) duly performed as designed. MLPV fell from $22 last Summer to under $5 at which point the abovementioned mandatory redemption was triggered. The more seasoned MLPL reached $75 at the MLP peak in August 2014 and recently touched $10. Incidentally, the management of vehicles such as these requires selling MLPs when they fall and buying them when they rise to maintain constant leverage, the type of behavior that has exacerbated the sharp moves in the sector recently and causes a permanent loss of capital for the investor. The clients of UBS were poorly served indeed.

We are long BPL, CEQP, KMI and WMB